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Limitations of the Efficient Market Hypothesis
The concept of Efficient Market Hypothesis has weak foundations. The effectiveness of these hypothesis depends upon validity of one of the three conditions viz. rational investment decisions, independent irrational investment decisions, and arbitrage. In practice, none of these three conditions are valid. An alternative approach, to explain capital market behavior, based on psychology is gaining importance in the field of finance.
The Behavioral Challenge to Market Efficiency
According to behavioral finance, none of the above three conditions are likely to hold good in reality.
1. Rationality: Investors are not always rational. Many investors do not achieve the degree of diversification that they should. Most of the investors trade frequently and incur higher brokerage costs and taxes. Actually, taxes can be minimized by selling losers and holding winners. But many investors do just the opposite. The view of behavioral finance is that, not all investors are rational. Thus, the first condition for market efficiency does not hold good in real world.
2. Independent deviations from rationality: Deviations from rationality are not random, thus they are not likely to cancel out in a whole population of investors. It is not uncommon in the market place that investors over value an upcoming new sector like internet, information technology or biotechnology. In these cases, investors believe that current performance of these sectors is representative of the future performance. This behavior of representativeness leads to bubbles in the markets, which is not explained by efficient market hypothesis. On the other hand, there are some conservative investors who are too sluggish to adjust to new information. This results in a slow process of price adjustment to new relevant information. This is against the concept of efficient market hypothesis.
3. Arbitrage: Though, in theory, arbitrage is a risk-less process, in practice it is likely to be more risky. Suppose professional investors generally believe that Tata Motors is under priced. They would buy it, while selling their holding in Maruti Suzuki. However, if amateurs were taking opposite positions, price would adjust to correct level only if the positions of amateurs were small relative to those of the professionals. In a world of many amateurs, a few professionals would have to take big positions to bring prices into equilibrium, perhaps even engaging heavily in short selling. Buying large amount of one stock and short selling large amount of other stock is quite risky, even if the two stocks are in the same industry. Here, unanticipated bad new about Tata Motors and unanticipated good news about Maruti Suzuki would cause professionals to register large losses. Apart from that, even if amateurs did actually misprice Tata Motors and Maruti Suzuki, there is no guarantee that this mispricing would be corrected in short term. This also causes professionals to register losses by liquidating their positions before the equilibrium is established in the prices.
Limits to Arbitrage: Arbitrageurs face practical risks costs while exploiting mispricing and facilitating establishment of equilibrium in prices. The first risk is fundamental risk. This risk exists due to non-existence of perfect substitute stock for mispriced stock. For all practical purposes Maruti Suzuki is not a perfect substitute for Tata Motors even though both the companies operate in the same industry. They differ in terms of sales volume, product profile, management style etc. The second risk is noise trader risk. This is risk that mispricing being exploited by the arbitrageurs worsens in the short run. The possibility of the price of Tata Motors stock going further down and the price of Maruti Suzuki stock going further up due to company specific bad or good news can not be ruled out. Once one has granted the possibility that a security's price can be different from its fundamental value (equilibrium price), one must also grant the possibility that future price movements will increase the divergence between actual value and fundamental value. Noise trader risk forces arbitrageurs to liquidate their positions early, bringing them potentially steep losses. The third limitation of arbitrage process is implementation costs. Transaction costs such as brokerage costs and taxes can make arbitraging less attractive. There are real life examples of how these limitations of arbitrage kill the process of arbitrage.
We have seen in companies like Enron and Worldcom, how managers dupe investors through creative accounting. Firms successfully time their debt and equity issues by issuing equity during bullish equity market and debt during bearish equity markets. Firms do cancel IPOs even just before the opening of the issues, like Wockhardt Hospitals and Emaar MGF, if market conditions change against equity. Firms also defer their IPOs, like ICICI Securities Ltd, due to adverse market for equity offerings. We also have evidences of insider trading, managers and promoters benefitting from inside/private information.
In conclusion, the arguments presented here suggest that the theoretical underpinnings of the efficient capital markets hypothesis might not hold well in reality. That is, investors may be irrational, irrationality may be related across investors rather than cancelling out across investors, and arbitrage strategies may involve too much risk to eliminate market inefficiencies.
Efficient-market hypothesis - Wikipedia
Since the beginning of the fall of monetarism in the mid-1980s, mainstream macroeconomics has incorporated many of the principles of post-Keynesian endogenous money theory. This paper argues that the most important critical component of post-Keynesian monetary theory today is its rejection of the “natural rate of interest.” By examining the hidden assumptions of the loanable funds doctrine as it was modified in light of the idea of a natural rate of interest—specifically, its implicit reliance on an “efficient markets hypothesis” view of capital markets—this paper seeks to show that the mainstream view of capital markets is completely at odds with the world of fundamental uncertainty addressed by post-Keynesian economists, a world in which Keynesian liquidity preference and animal spirits rule the roost. This perspective also allows us to shed new light on the debate that has sprung up around the work of Hyman Minsky, calling into question to what extent he rejected the loanable funds view of financial markets. When Minsky’s theories are examined against the backdrop of the natural rate of interest version of the loanable funds theory, it quickly becomes clear that Minsky does not fall into the loanable funds camp.
One such error that might explain overreaction in stock ..
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