EMH & Investor

Psychology
Presented By:
Prof. Divyang Joshi
Faculty
SGPIMS- Dharmaj

Efficient market hypothesis

The efficient market hypothesis was first expressed by Louis Bachelier, a
French mathematician, in his 1900 dissertation, "The Theory of
Speculation". His work was largely ignored until the 1950's;
Efficient market hypothesis (EMH) is an idea partly developed in the
1960s by Eugene Fama.
It states that it is impossible to beat the market because prices already
incorporate and reflect all relevant information.
This is also a highly controversial and often disputed theory. Supporters
of this model believe it is pointless to search for undervalued stocks or
try to predict trends in the market through fundamental analysis or
technical analysis.
Under the efficient market hypothesis, any time you buy and sell
securities, you're engaging in a game of chance, not skill. If markets are
efficient and current, it means that prices always reflect all information,
so there's no way you'll ever be able to buy a stock at a bargain price.

Weak-form efficiency
No excess returns can be earned by using investment
strategies based on historical share prices or other
financial data.
Weak-form efficiency implies that Technical analysis
techniques will not be able to consistently produce excess
returns, though some forms of fundamental analysis may
still provide excess returns.
In a weak-form efficient market current share prices are
the best, unbiased, estimate of the value of the security.
Theoretical in nature, weak form efficiency advocates
assert that fundamental analysis can be used to identify
stocks that are undervalued and overvalued. Therefore,
keen investors looking for profitable companies can earn
profits by researching financial statements.

Semi-strong form efficiency

Share prices adjust within an arbitrarily small but finite
amount of time and in an unbiased fashion to publicly
available new information, so that no excess returns can
be earned by trading on that information.
Semi-strong form efficiency implies that Fundamental
analysis techniques will not be able to reliably produce
excess returns.
To test for semi-strong form efficiency, the adjustments to
previously unknown news must be of a reasonable size
and must be instantaneous. To test for this, consistent
upward or downward adjustments after the initial change
must be looked for. If there are any such adjustments it
would suggest that investors had interpreted the
information in a biased fashion and hence in an inefficient
manner

Strong-form efficiency
Share prices reflect all information and no one can earn
excess returns.
If there are legal barriers to private information becoming
public, as with insider trading laws, strong-form efficiency is
impossible, except in the case where the laws are universally
ignored. Studies on the U.S. stock market have shown that
people do trade on inside information.
To test for strong form efficiency, a market needs to exist
where investors cannot consistently earn excess returns over
a long period of time. Even if some money managers are
consistently observed to beat the market, no refutation even
of strong-form efficiency follows: with tens of thousands of
fund managers worldwide, even a normal distribution of
returns (as efficiency predicts) should be expected to produce
a few dozen "star" performers.

EMH Tenets and Problems with EMH

First, the efficient market hypothesis assumes that all
investors perceive all available information in
precisely the same manner. The numerous methods
for analyzing and valuing stocks pose some problems
for the validity of the EMH. If one investor looks for
undervalued market opportunities while another
investor evaluates a stock on the basis of its growth
potential, these two investors will already have arrived
at a different assessment of the stock's fair market
value. Therefore, one argument against the EMH points
out that, since investors value stocks differently, it is
impossible to ascertain what a stock should be worth
under an efficient market.

 Secondly, under the efficient market hypothesis, no

single investor is ever able to attain greater profitability
than another with the same amount of invested funds: If
no investor had any clear advantage over another, would
there be a range of yearly returns in the mutual fund
industry from significant losses to 50% profits, or more?
According to the EMH, if one investor is profitable, it
means the entire universe of investors is profitable. In
reality, this is not necessarily the case.
Thirdly (and closely related to the second point), under
the efficient market hypothesis, no investor should ever
be able to beat the market, or the average annual returns
that all investors and funds are able to achieve using their
best efforts. There are many examples of investors who
have consistently beat the market - you need look no
further than Warren Buffett to find an example of
someone who's managed to beat the averages year after
year

Advantages of EMH
If the EMH is correct there is no need for
investors to pay the high fees charged by
investment managers and the analysts,
researchers and fund managers. Just invest in
index fund and can earn market return.
Track the index fund, no worries about wrong
selection of the stock.
No one can earn superior return. All will have
same return.

Disadvantages
No extra return. Investors have to happy with
the index/market return.
no motivation for being invested in stock
market.

Investor Psychology
Q-1. You have Rs 10,000 for making investment in
the following options. Which option would you
select?
1) 30% probability to earn 5000 Rs
2) 40% probability to earn 4000 Rs
Q-2. What was high made by NIFTY 50 in 2008?
1) 6387
2) 6257
3) 6417
How much confident are you? ______%

Q-3. In the period of higher volatility in stock

market, which group of stock would you prefer
to sell?
1) The one which earn profit.
2) The one which earn loss.

Q.4. What do you think is the role of intuition

(your internal feeling) while taking decision for
an important problem?
1) No effect
2) Little effect 3) High effect

Q.5 What was Inflation rate in September 2013?

1) 6.45%
2) 6.46%
3) 6.48%
How much confident are you? ______%
Q.6 You are having following stocks in your
portfolio. You are in need of 150,000 Rs. Which
stock would you like to sell?

Q.7 From your holdings, for specific company there are

rumors that company is in Problem, what will you
do?
1. Indifferent
2.Maintain position/ keep investing.
3. Reduce/ sell half of the share.
4. Sell all shares and liquidate position.

Q.8 Your friend had purchased RIL @ price of Rs 1200

and it goes high up to Rs 2500. Now due to
uncertainty price goes down to Rs 700. Your friend
bares big loss. Do you think this was...?
1) A Mistake
2) A bad luck

Q.9 From your holdings of different companies share, there is

positive news for specific company. What will do?
1) Indifferent
2) Maintain position/ keep investing
3) Increase/ purchase half of the share
4) Sell other share and invest in news specific company
Q.10 During your investment experience, what contribution has
been made by following factors which led you towards profit?

Q.1 & Q.4 Rationality

Q.2 & Q.5 Overconfidence
Q.3 & Q.6 Disposition Effect
Q.7 & Q.9 Conservation
Q.8 & Q.10 Regret Theory

Biases of Judgment
Psychology is the scientific study of behavior and mental
processes, along with how these processes are affected by a
human beings physical, mental state and external
environment.
Decision making includes beliefs and preferences.
Decisions theorists argue that any significant decision can be
described as a choice between gambles, because the
outcomes of possible options are not fully known in advance.
People make judgments about the probabilities; they assign
values (sometimes called utilities) to outcomes; and they
combine these beliefs and values in forming preferences
about risky options.
That is called Judgment. In Judgment the systematic error is
called Biases of Judgment.

Rationality
A rational decision is one that is not just reasoned, but is
also optimal for achieving a goal or solving a problem.
Rabin (1998) discussed and compared the view of
economist and psychologist and concluded that in short
duration investors were irrational but in long duration the
human nature became rational.
In question-1, investors who supposed to be rational would
like to select option 2 because compare to option 1 option
2 is profitable.
In question no. 4 As per Rationality theory of behavior
finance, intuition of investors is not playing any role in
deciding or taking decision. The investors who are Rational
they select option 1, that contain no effect of intuition
and who are irrational investors they select option 2 & 3

Disposition Effect
The common behavior of investors to hold
looser stocks too long and sell the winner stock
too early is called disposition effect (Grinblatt
and Han, 2002). Investors may rationally, or
irrationally, believe that their current losers in
future will outperform their current winners.
They may sell winners to rebalance their
portfolios or they may refrain from selling losers
due to the higher transactions costs of trading
at lower prices.
The Q.3 and Q.6 when person sells the winner
and the looser, it is disposition effect.

 Regret theory
According to Investopedia simply regret theory deals with the
emotional reaction people experience after realizing they've
made an error in judgment. Faced with the prospect of selling a
stock, investors become emotionally affected by the price at
which they purchased the stock. So, they avoid selling it as a
way to avoid the regret of having made a bad investment, as
well as the embarrassment of reporting a loss.
Overconfidence
Overconfidence defines as an overestimation of the
probabilities for a set of events by Mahajan, J. (1992).
Operationally, it is reflected by comparing whether the specific
probability assigned is greater than the portion that is correct
for all assessments assigned that given probability. J.
Michailova (2010) tests the overconfidence bias among the
gender with the help of questionnaire of 50 questions. She
concludes that there is no significant difference among
expressed overconfidence by both the genders and they did not
appear to be associated with overconfidence.

 Conservatism
Conservative is simply means traditional. Conservatism as
psychological attitude means human being has some excess
attachment to the things which they have already with them.
And something new offer to them then they are not ready to
accept that new thing or slowly and gradually they are accept
that new thing. Edward (1962) explains conservatism bias. It
means Investors are too slow (too conservative) in updating
their beliefs in response to recent evidence. This means that
they might initially under react to news about a firm, so that
prices will fully reflect new information only gradually. Such a
bias would give rise to momentum in stock market returns.
Financial Cognitive Dissonance
As individuals, we attempt to reduce our inner conflict
(decrease our dissonance) in one of two ways: 1) we change
our past values, feelings, or opinions, or, 2 we attempt to
justify or rationalize our choice. This theory may apply to
investors or traders in the stock market who attempt to
rationalize contradictory behaviors, so that they seem to follow
naturally from personal values or viewpoints.

Mental Accounting
Narrow framing.
Investors if offered for gamble, they evaluate
it as it is the only gamble they face in the
world rather than merging it with the preexisting bets to see the new bet is worthwile
or not.

Situation of ambiguity
Prospect theory
Prospect theory deals with the idea that people
do not always behave rationally. This theory holds
that there are constant biases motivated by
psychological factors that influence peoples
choices under conditions of uncertainty.
There are 2 box. In 1st box 50 Red balls and 50
blue balls. In 2nd box 100 balls are there, but
colored not known. You offered to select one ball
from the box without seeing. If it is red you will
earn 1000 Rs. Which box u will preferred?

Thank You