Efficient Market Hypothesis & Behavioural Finance

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The 2013 Nobel Prize for economics has been awarded to a trio of American academics for their work on what drives asset prices. Eugene Fama, Lars Peter Hansen and Robert Shiller have all spent their careers analysing how the value of assets, such as stocks and bonds, vary over time. However, mirroring the broad disagreements which typically characterise the economics profession, the three scholars have come to radically different conclusions.

 Mr Fama, from the University of Chicago, is one of the fathers of the so-called “efficient market hypothesis”. This theory – which underlies his seminal 1965 paper “Random Walks in Stock Market Prices” – formulates that markets are “informationally efficient”, as investors immediately incorporate any new available information in the price of an asset. In contrast to Mr Fama, Mr Shiller, from Yale University, believes that any explanation of investors’ behaviour cannot be fully based on rationality and must acknowledge the role played by psychology. In the 1980s, he showed that stock prices tend to fluctuate more than corporate dividends. This should not happen if investors were fully rational, since stock prices forecast future dividends. Mr Hansen, a co-founder of the Becker Friedman Institute also at the University of Chicago, designed methods to explore the drivers of stock market volatility. His statistical brainchild – called the “Generalized Method of Moments” – confirmed Mr Shiller’s finding that swings in asset prices could not be explained via standard models based on rationality. Subsequent work has shown that at least some of this volatility can be explained by investors’ different attitude towards risk.

The surprise was probably best summarized by Paul De Grauwe, professor at the London School of Economics who tweeted: “Nobel Prize for Fama who led millions to believe financial markets are efficient and for Shiller who showed opposite. What a contradiction,” . But is this really a surprise?

  • You have recently joined a large American Fund Management company as a trainee. Your boss has been asked to present a lecture to a number of potential clients discussing efficient market hypothesis (EMH) and behavioural finance (BF). She, however, graduated from the University about 30 years ago. In confidence, she asked you as a current M-level finance student, to prepare her a formal memorandum setting the ground for her presentation. In particular, in very clearly separated sections, please: (1). Present the EMH concept and critically discuss its assumptions -  (2). Discuss the concept, assumptions and key concepts of BF – ( 3). Please present the practical (in terms investment/asset allocation) applications of both EMH and BF, including the work of Messrs Fama and Shiller -  4. Based on your analysis above, please debate whether the Nobel Prize Committee saw common features in the work of these academics; -  Your manager requires a fully referenced paper (using Harvard Referencing), using a mix of textbooks, academic journals, quality press (The Economist, Financial Times, WSJ, Forbes) and quality internet sources (Vox, Open Europe, Brookings or similar).
  •  The manager made a clear reference to company’s policy that Wikipedia is NOT an appropriate referencing source

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