Financial Theory & Markets
The financial aspect of the market can essentially be subdivided into two main theories that is the Behavioral Finance and Efficient Market Hypothesis (EMH). The market hypothesis efficiency affirms that an efficient market has to reflect all the relevant information at a given time. According to Fama, efficient capital markets are where the joint distribution of security prices at a period is identical to the joint distribution of prices that would exist if all relevant information available at that period were used (Thaler, 2016). In a nutshell, market efficiency examines in length the relationship between available information and the stock prizes. Therefore market efficiency leads to the question of beating the market by investors and whether the ideology is really effective in a complete, efficient market. Beating the market means merely constantly making positive returns whenever one invests in the market. The constant efficiency of a market makes it hard for the investors to penetrate into it.
Efficient capital markets are dependent on information. An information structure may be defined as a record of various events which may happen hence the value of information structure. From this information, a formulae can be generated to determine whether an efficient market does exist (Prosad, Kapoor, & Sengupta, 2015).
V (η) = Σ q (m) MAX Σ p (e/m) U (a, e) – V(η o)
m a e
Where;
q (m) = the marginal probability of receiving a message m;
p (e/m) = the conditional probability of an event e, given a message m;
U (a, e) = the utility resulting from an action a, if an event e occurs;
V (η o) = the expected utility of the decision make without the information
In determining whether an efficient market exists, the value of the gain from the information to an individual must be zero. In a capital efficient market, the current relevant information structure of the prices has already surpassed the past prices histories. As a result, it is not possible to develop trading rules based on the past prices given that they will allow any individual or business to outperform the market. Nigeria Stock Exchange is a perfect example of weak form of an efficient market. Using past information structure in terms of structure in such a market will make it impossible to develop sound trading rules because the current prices have bettered the past price histories. Determining efficient markets have an information gain of zero;
V (η i) – V (η o) = 0 (2)
According to the above equation, no individual would pay for the information set from the historical prices. However, it is prudent to note that it is after only certain considerations are made with respect to the costs of acquiring the information and undertaking specific pursuant actions can capital markets be considered efficient (Prosad, Kapoor, & Sengupta, 2015).
Figure 1: Efficient Market Hypothesis (EMH) Source: Seadna Finnegan (2014)
However, there are theoretical and empirical assumptions of the Efficient Market Hypothesis (EMH). Among the theoretical assumptions is that, investors are assumed to be rational hence securities are valued rationally incorporating all the available information and if there are irrational investors they trade randomly hence their trades cancel each other. Empirical assumptions include; it considers the impact of new information on security prices and security price is equal to its value hence it can only change when there is news information that affects its fundamental value (Akintoye, 2008).
On the other hand, the concept of utility was introduced during the mid-eighteenth century (classical economical period). Utility is defined as the measure to which a good or a service satisfies an individual after consumption. The utility theory is based on three assumptions which are; perfect information, perfect rationality and perfect self-interests. The principle aim of individuals in this concept is uniform given that it is solely aimed at optimizing their marginal gains. The basic assumption of this theory is based on human rationality (Akintoye, 2008). Human rationality focuses on two aspects. Firstly, when individuals receive new information they update their beliefs correctly and secondly, individuals make decisions that will increase their expected utility based on their beliefs.
Using the utility theory, investing can clearly be explained. This is because it mainly aims to assess the benefits and nature of the investment process in the market. According to the utility theory, investment is mainly done under massive uncertainties of future payoffs. In that, all financial assets are purchased according to their future payoffs which are considerably uncertain. However, very few investors will engage in a business deal that is infinite or has no adequately defined ends of returns (Gupta, & Sankalp, 2017). Most of them invest for the sake of unlimited returns before they can terminate their investment worthwhile. Therefore utility theory aims to resolve the uncertainty issue through the cardinal and ordinal theories which have been conceptualized by Henderson and Quaint. Both theories are specific on the laws that govern people’s allocation of their resources and the redistribution of wealth within the society.
Cardinal utility is specific on the amounts consumers are willing to offer a particular asset or commodity according to the degree of utility. On the other side, ordinal utility only focusses on the ranks and estimates that are associated with the degree of utility of the commodity. In that the consumer has no interest whatsoever in placing arbitrary units on the product before making purchase, they are solely governed with ranks and estimates. The article on Tesla by Clair Kearney gives detailed market changes that the company faced over time with all the ups and downs that are real in the market. The article proves beyond doubt that it is almost impossible to beat the market when such a big company can almost undergo bankruptcy. Market efficiency stresses on the stock market and the availability of information to all the stakeholders. Additionally, market research is skeptical about beating the market and making constant returns like most investors expect.
The article on Tesla helps in defining the uncertainties in the investment world which is subject to a lot of risks. Cardinal and ordinal utility helps in explaining the purchase of commodities by consumers and the uncertainties involved. Ordinal utility disregards the subject of arbitrary units and that might be detrimental to investors especially in an unreliable company like that of Tesla. Consequently behavioral theory of finance conceptualizes psychology theories to explain changes in the market or market anomalies. Some of these market anomalies include the rise or fall of stock prices after a given period of time.
Over time, standard finance theories were unable to provide sufficient explanation for certain anomalies in the Stock Market Exchange. The dot-com bubble and real estate bubble are examples of unexplainable market behaviors. During these phases, individuals disregard the fundamental valuation and get attracted to overpriced securities which further strengthens the mispricing. The end result of such behavior is that companies fail to achieve their targets and the demand for such commodities and services decline. This situation defies the four pillars of standard finance theories which are; rational investors, efficient markets, investors design their portfolios in accordance to the rules of mean variance and expected returns are functions of risk alone.
Figure 2: How Behavioral Bubbles Happen Source: Adam Nash (2013)
Behavioral finance is a branch of social psychology that utilizes the human concept of decision making. Behavioral finance seeks to explain how humans make social, economic and even financial decisions while taking into consideration certain sentiments such as pride, insecurity and egotism. Proponents of this theory explain that it is impossible for an individual to make a decision that is entirely devoid of emptions. This theory assumes that the rationality of individuals is limited by the information available and the cognitive limitations to the mind. Daniel Kahneman and Amos Tversky introduced the concept of prospect theory which is key in the understanding of behavioral finance. Prospect theory focusses on three key aspects. Certainty effect, status quo and loss aversion (Prosad, Kapoor, & Sengupta, 2015).
These behavioral theories explain what motivates consumers to consume and purchase commodities. The brain is comprised of three major parts that are the cortex, limbic system, and recumbent part. Limbic system deals with emotions, cortex deal with logic and recumbent part with body functions. The main factor that is discussed in the behavioral theories is the biasness of the brain according to past experiences and state of mind. All these concepts are important to in explaining the world of finance, purchase and above all investment. Firstly, the efficient market hypothesis examines the ability of the market to lay bare all the relevant information that concerns stock markets (Becker, 2017).
Figure 3: Efficiency and Markets (Subsidy Graph) Source: Robert Schenk (2012)
The ability of the market to be honest about stock prices and securities is priceless since it is easier for investors to make business decisions (Yang, Ryu, & Ryu, 2018). The investor can critically analyze the market according to the information received before actually engaging his or her finances. On the other hand, market efficiency research also annuls the ability of the investors to be able to beat the market. That is all investors have an expectation at the beginning of their investment to make certain profits at the end of every financial year. According to market efficiency, beating the market is not possible in a free and fair market structure where everything is laid bare for the stakeholders. The market is severely unpredictable and the article on Tesla shows how bad it can get at times with the ups and downs that are inevitable in a business environment.
Secondly, utility theory is the main backbone of the investment process because it focuses on the uncertainties that are involved before purchase or investment. Utility theory explains the power of uncertainty through two theories that is, cardinal utility and ordinal utility. Cardinal utility will help the investor to first gauge the price tag placed on a particular commodity according to the degree of utility or the quantity and quality of the product involved. On the other hand, the ordinal utility might be risky for the investors since there are no arbitrary units placed on the product (Bhattacharya, 2018). The product is associated with others in ranks and then an estimated value is arrived at without extreme consideration on the actual degree of utility. The amount of risks that are faced through these utility theories, however, helps the investor to deal with the uncertainties that are involved in the business environment.
Thirdly, behavioral theory examines the relationship between psychology and finance. In that what guards the power of investment and how do psychological features affect the whole process? The only secret to making rational investment decisions is to be rational at all times to avoid being affected by excitement and other external psychological factors. Excitement and the fear of loss are part of the main factors that affect the psychological balance of investors. Even though all investors expect huge returns, all of them possess the fear of the unknown even if they do not show it more often. Furthermore, decision making is also a big problem for them since they have various choices to consider and sometimes the endeavor becomes overwhelming. Most importantly, all investors are affected by behavioral biases which stick with them due to life experiences. Firstly, confirmation bias which explains how people are many a time inclined towards already known information. Therefore all the decisions made should first concur with already known information.
Figure 4: Fundamental Valuations Source: StockCharts (2015)
Fourthly, there is the theory of illusion of control where one is overconfident because of past success. For example, where one initially realized huge profits from a particular stock market endeavor, hence he or she believes the same scenario will have to repeat itself. Thirdly there is the high sight bias where people are obsessed with making predictions (Davies, & De Servigny, 2012). Just like in the illusion stage, these people will use one successful prediction to try all other investment decisions. On the other side, behavioral theories of finance set the stage for investors to invest wisely. For example, the theories warn investors against involving emotions and being disillusioned while carrying out the whole process. The following are some of the tips which might be priceless for the investors from the behavior theory of finance.
Preparation of all outcomes at the beginning of the investment process; when the investor prepares for all outcomes he or she becomes more rational and confident, it is imperative to think about failure since one can devise ways of avoiding it rather than just assuming it all together. More so, the investor needs to engage in substantial market research. Participating in the research will help in reducing the emotions and the fears which essentially affect investors. The investor after doing sufficient extensive research will be able to know what to expect at the end of the day. In addition to research, the investor can also narrow down his or her options to avoid confusion. Too many options will rob the investor of his or her ability to make sane choices; therefore, narrowing down the options can help in decision making (Kearney, Claire 2018).
In a nutshell, behavioral theories of finance pose very serious questions for the efficient market and efficient market hypothesis however it does not make it redundant. Efficient markets deal with the market price of the securities which must be unbiased in relation to the intrinsic value of the market. Psychological theories might guide the investor well but without the stability of stock prices, the investor will end up making decisions however rational he or she is at the end of the day (Lim, & Brooks, 2011). On the other hand, behavioral theories pave way for research and rationalism which eventually helps the investors in making good choices. It is also important to note that behavioral theories focus on psychology and emotions while market efficiency concentrates on the market.
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