Saturday, March 30, 2019
Efficient Market Hypothesis and Behavioural Finance
Efficient securities industry Hypothesis and Behavioural finance1.1 Aim of ChapterThis chapter aims to give an overview of the dissertation. To start with, world(a) backgrounds concerning the efficient securities industry hypothesis (EMH), behavioral finance and securities industry anomalies ar mentioned briefly in order to provide better understanding some the modern atomic number 18a of financial debate. Then, twain opposed concepts of investment st ordinategies, Contrarian Strategies and caprice Strategies, be addressed leading to the next section which mention the briny purpose and summary of findings of this research. Lastly, the structure of the dissertation has been outlined at the difference of the chapter.1.2 Background of knowledge about efficient merchandise hypothesis (EMH)The possibility of commercialise hypothesis (EMH) is one of the most crucial theories in amount finance that extradite been revised and tested over the past fewer decades to uncover i ts imperfection. This hypothesis was introduced by Professor Eugene Fama in 1970. As delineate in his article, the efficient market is the market where securities be priced, at twain point of beat, by access codeible in ruleation. It is believed that the markets are extremely efficient that individualistic contrasts and threadbare markets as a whole are fully reflected by all operable hit-or-missness. When new nurture enters the market, clove pink prices incorporates the news and responds actually quickly with our any delays therefore surety prices are the accurate parentage of selective information which can be physical exercised as signals in concern investment process. By examining the level of how relevant information reflects in security prices, Fama (1970) categorizes the market efficiency into three forms timid, semi-strong and strong forms of EMH. However, this theory relies on veritable assumptions, for example, there is no transaction cost paid in pr ofession securities and it is costless for all participants to gather information available in the markets.The weak form of EMH is the condition that exists when share prices are fully reflected by craft info such as past price (or return) histories. For that reason, investors cannot exploit mispriced securities and gull intemperance returns by using historical demarcation quotations or charts.Semi-strong form of EMH is the condition that exists when share prices incorporates market trading data and publicly available information. The examples of this type of information are announcements of annual honorarium, course splits, annual reports, psychoanalyst forecasts, etc. As a consequence, investors cannot exhibit gains by rely except on fundamental and macro-economics data.Strong form of EMH is the condition that exists when market prices of stocks adjusted according to every kind of accessible information. This includes hidden inside information which are known among specif ic free radical in the company (e.g. the eliminate executives and group of operational managers) or some individuals that have monopolistic access to information (e.g. managements of mutual funds). so, abnormal profits cannot be generated by all using internal or external information of the company. In opposite words, twain individual and professional investors cannot beat the market and earn excess returns in every way due to the perfect efficiency of the stock markets.As claimed by efficient market hypothesis, market testament be efficient in weak form if the past and future returns are not correlated, in other words, they are independently and identically distributed. Thus this refers to the idea of the random walk model. However, Fama (1970) affirms in his literature that the test of random walk model leads to the evidence of weak-form EMH, but not vice versa.Burton (2003) identifies the comment of random walk in his paper that it is the state where the flow of informati on on specific day is incorporated in stock prices on that day only, not for the subsequent period. The news announced in the market is unpredictable, thus stock prices changes are displayed in a random pattern. As a consequence, uninformed investors are able to earn equal rate of returns as what achieved by professional investors if they long position in intimately-diversified portfolios. In his paper, Burton tries to read the criticism of the efficient market hypothesis and the idea that stock prices can be predicted based on initial valuation parameters (e.g. price-earnings ternary or dividend yield). He uses time-series analyses of accounting numbers and multiples and comes up with the results fall aparting that the stocks market are efficient enough, but it is difficult to predict the share prices. Moreover, the findings withal reveal that anomalous behavior of stock prices may exist, but investors cannot render portfolio trading opportunity and gains excess risk adjusted returns.Fama (1997) states in his body of work that there are many literatures concerning behavioral finance and market anomalies argufy the hypothesis of efficient market. The opposed idea suggests that stock prices slowly cozy up information available, which can be denoted as the market inefficiency.1.3 Behavioral Finance and Market AnomaliesBehavioral finance is the new area of financial study concentrating on the psychology of market and its participants. This field of study has started to appear in many academic journals from 1990s. Shefrin (2002) publish a book regarding the behavioral finance trying to find and explain reason behind the behavior of investors, both professional and individual. The author suggests that investors, who are sometimes prone to commend mistakes and errors, race to rely on their emotional and psychological forces, thus this constructs many market anomalies, the state where there is inefficiency in stock markets, to take place.Two well-known pa pers of Berberis, Shleifer, and Vishny (1998) and Daniel, Hirshleifer, and Subramanyam (1997) proposed behavioral models to explain the conflicting theory of efficient market hypothesis. They reject the previous belief with the proposition that the behavioral biases (i.e. judgment bias) of investors cause the anomalies and knock down the old theory behind. They present the concepts of over-reaction and under-reaction which accommodates the existence of long excess returns.Berberis, Shleifer, and Vishny (1996) create a model based on cognitive psychology of two judgment biases the representativeness bias and conservatism. In their study, the empirical findings of investors behaviors are divided into two main groups one perceives that earnings are mean-reverting. Thus, stock prices show a delayed short-term response and under-react to change in earnings. Another group believes that firms earnings are trending which leads to the overreaction in stock prices. The earnings follow the ra ndom walk process hence, this leads to reversal of long-term returns.Daniel, Hirshleifer, and Subramanyam (1997) have antithetical views in conducting the behavioral models. They split the sample group of investors into two categories informed and uninformed investors. They find that judgment biases are not build among the uninformed investors, but detected among the informed ones. Informed investors are the group of people that determine the stock prices. They are exposed to two kinds of behavioral biases overconfidence and self-attribution biases. Overconfidence causes the overstatement in investors perception of their private stock prices signals, while self-attribution bias causes investors to underweight the public signals about the value of companies. Therefore, the considerateness of overreaction to private information and under-reaction to public information generates continuation of stock returns in the short run. Overreaction leads to the concept of contrarian investme nt, whereas underreaction induces the theory of nervous impulse investing.1.4 Investment Strategies1.4.1 Contrarian InvestingContrarian investing is the strategy that aims to generate profits by investing in the military commission that goes against the conventional investors. In normal condition, short-sighted investors, who overweight the recent trends of past stocks prices and use this information to predict future prices, engage in buying stocks with wakeless performance in the past hoping that it will continue to perform well in the near future. However, contrarian investing focuses on the opposite direction. People who implement this strategy tend to buy the shares that others have given up on due to either their poor past performance or their reprehensible and unclear future prospect. They expect the market to react to the behavior of the crowd, so that they can exploit the mispricing of securities and earn abnormal returns.1.4.2 impulse InvestingMomentum investing is t he strategy that is the opposite of contrarian investing. People who employ this strategy prove for making profits by relying on the continuance of the past stock prices and trends in the market in an attempt to predict prospective prices in the future. It is believed that the good stocks with price increases and strong performance in the past will keep on outperforming and generate gains in the future, and vice versa for the poor stocks. Thus, momentum investing suggests investors to hold stocks that had high returns and sell those that had low returns (buy winners and sell losers).The expand of these two investment strategies will be discussed in the next chapter which both strategies will be supported by animate empirical evidences from several(prenominal) renowned academic papers.1.5 Purpose and Findings of the ResearchThe purpose of this research is to examine the profitability of momentum strategies, which is one of the most debated investment strategies in financial study, in the UK stock market. This paper employs the prices and returns data of FTSE blow composites the top 100 biggest companies in London Stock Exchange as a procurator of the whole UK stocks. The observation period lies between July 21, 2000 to July 21, 2010, which gives a total of 10 years period.Thus, the main contribution of this study is to comprehensively revise existing literatures and employ the more up-to-date the data set with the well-known occasion to test the existence of momentum investing and its profitability in the UK market.However, the findings reveal no evidence of momentum profitability in the observed time for UK stock market, which are inconsistent with the prior research conducted using the different sample periods.1.6 Structure of the DissertationThe rest of the dissertation is organized as follows Chapter two comments on the review of the literature regarding the momentum strategies and its criticism, including the opposed theory of contrarian investing. Academic papers concerning the momentum strategies are divided into categories regarding the region of data employed. We carefully asserted and analyzed each paper to find the gaps which are necessary to be concerned for further researches in the future. Then, chapter three gives an overview of data and methodology used in this research. Chapter four shows the summary statistics of data, empirical results and interpretations. Finally, bear chapter provides a summary of the results, as well as the limitations of the study.