Recent stock market movements and other events have shaken investors' confidence. They've also raised questions about the applicability of established financial theories, Efficient Market Hypothesis (EMH) and Behavioral Finance Theory.
Behavioral Finance seems to present a stronger foundation for understanding current conditions. That's because investors are more inclined to follow their impulses than to base their decisions on in-depth analysis. How else to consider that markets are tanking, although the U.S. economy, widely considered the world's most important, and several other key markets are performing capably? Unemployment and energy prices are low and inflation seems well in control, as well.
In Behavioral Finance, investors make decisions that are based more on their risk appetite than on information. EMH posits that investors make decisions rationally based on all available information and that stocks always trade at fair market value. Investors are unable to best the stock market's performance.
Let's consider these theories in depth.
Efficient Market Hypothesis
The 2013 Nobel laureate in Economic Sciences, Eugene F. Fama, developed EMH in early 1970. The theory, which held strong until the 2008 financial meltdown, holds that financial markets are efficient, and that investors make rational, informed decisions.
In other words, asset prices fully reflect all information making it impossible for investors to either purchase undervalued stocks or to sell stocks at inflated prices. The theory states that investors cannot outperform the markets predictably or consistently. They can do so only if they buy riskier assets.
EMH theory was highly criticized during the Great Recession of 2007-2008 by economists and academicians like former Federal Reserve chairman Paul Volcker and Yale economist Robert Shiller. Volcker said that there was a considerable amount of unjustified faith in "rational expectations and market efficiencies."
Indeed, the rise of social media has now made it difficult to track every shred of information, or at least may make it difficult to make sense of rapidly evolving circumstances. It is not unusual today for information to conflict. Such instances may leave investors with nothing more to latch on to than the herd. The 2013 Nobel Prize-winning behavioral economist has called the EMH "the most remarkable error in the history of economic thought."
Behavioral Finance Theory
Behavioral Finance Theory holds that investment decisions stem from changes in investor behavior rather than available information. The changes in investor behavior can lead to wide price swings and increases the volatility in financial markets. The University of Chicago economist Richard H. Thaler and Yale's Shiller (Yale University) have said that despite the available information, investors may make irrational decisions and trade in the stock markets at unjustified prices. Stock price movements may reflect mass psychology, even irrational trends. A study by Christoph Meier, a professor at the University of St. Gallen in Switzerland, found that overconfident investors may have a higher risk appetite and trade excessively.
Herd Mentality and Today's Markets
Recent stock market fluctuations suggest that herd mentality is behind investor behavior and consequent market fluctuations. Investors are responding to their perception of conditions and not taking the time to analyze data and events. In a recent paper, Eugene Fama said that stock prices can be "somewhat irrational" since ill-informed investors may theoretically cause markets to drift." Quipped Thaler: "I guess we're all behaviorists now."
That may be true, or perhaps Inefficient Market Hypothesis is the best moniker of all.