market efficiency cum anomalies or baahvior finance

Homo Oeconomicus 24(1): 81–93 (2007)www.accedoverlag.de Market Efficiency cum Anomalies,or Behavioral Finance?George M. FrankfurterLloyd F. Collette professor Emeritus at Louisiana State University, Baton Rouge, USA (eMail: pitypalaty@)Abstract The efficient markets hypothesis of Fama and the capital asset pricing model of Sharpe constitute the paradigm of what is often called modern finance. Although early, joint tests of both the hypothesis and the model showed the ‘signs’ of existence, serious doubts started to surface with the large-scale discovery of ‘effects,’ for which neither the former nor the latter could account. For a long time such effects were noted but largely dismissed as anomalies; deviations or depar-tures from the norm. It was not until prospect theory of Kahneman and Tversky found its way to the financial economics literature that an alternative logic of in-vestors’ behavior has been seriously contemplated and tested. This literature is re-ferred to by its practitioners as behavioral finance. Yet, the aficionados of modern finance call the empirical findings of behavioral finance as another set of anoma-lies. This paper is about the differences between modern and behavioral finance, and how the proponents of the former try to perpetuate their theory by referring to the latter as anomalies.Keywords market efficiency, behavioural finance, financial economics paradigm, modern financeWe have first raised a dust then complain we cannot see.— Bishop Bradley, Principles of Human Knowledge.1.IntroductionFama’s ‘Efficient Capital Markets: A Review of Theory and Empirical Work’ saw the light of publication (Fama, 1970) in 1970. The paper re-defined his earlier allusion to capital markets’ efficiency (Fama, 1965) and simply argued that in an efficient market prices reflect all what there is to know about a capital asset. Later, Fama’s efficient market hypothesis [EMH, subsequently] was ‘endowed’ with three distinct forms of ‘infor-© 2007 Accedo Verlagsgesellschaft, München.ISBN 3-89265-064-0 ISSN 0943-018082 Homo Oeconomicus 24(1) mational efficiency,’ namely, the weak, the semi-strong, and the strong forms.1Although the exact origins of these three forms are not explicitly known, or traceable, it is generally held that:•the weak form implies a random walk of some form (part of Fama’s 1965 definition of efficiency), and that one cannot take advantage of the knowledge of historical price movements,•the semi-strong form implies that prices at any given time incorporate all publicly available information, and•the strong form implies that prices at any given time incorporate all in-formation, whether public or private.The EMH revolutionized beliefs about the pricing and the operation of capital markets, because it was in line with an ideology that markets, whether capital or otherwise, know best. Accordingly, one must conclude that as a social policy, the best government can do is not to interfere with such operation because it would make something which is efficient (good) inefficient (the opposite of good), to be slighted and avoided.Sharpe (1964), Lintner (1965), and Black (1972) conjured up a statisti-cally testable model that described the pricing mechanism of capital assets. It should be remembered, thought, that both the EMH of Fama and the capital asset pricing model [CAPM, subsequently] of Sharpe described the operation and the characteristics of capital markets. That is, markets not just for stocks but all capital assets. Regardless, all subsequent tests of both the model and the hypothesis were done on a universe, some times even limited universe, of common stocks.In this paper I am discussing how doubts about both the model and the hypothesis surfaced, how the believers in the model have been trying to fight off efforts to replace them, and what language is being used to ac-complish the latter task.I will also offer my beliefs regarding the emergence of a possible alter-native paradigm and its future.2.Here come the effetsThe EMH and CAPM were internally consistent and connected in the sense that the latter provided a means for testing the former. This syn-thesis opened a door for empirical validation of both the hypothesis and1 There are also two other dimensions of efficiency, namely, allocational efficiency and liquidity. In the interest of the discussion here these other forms can be disregarded.G.M Frankfurter: Market Efficiency cum Anomolies 83 the pricing model. Through this door, or rather floodgate, thousands ofresearch papers marched to accept or reject the validity of either or boththe hypothesis and the model. A very large number of these empiricalstudies found that the theory couldn’t be rejected, based on the data thatwere available at the time.2Yet, after a while numerous studies have found results that showed theexistence of ‘effects’ that the CAPM could not explain or were consistentwith the EMH (that all relevant information is reflected in the price). Thelist of the ‘effects’ is rather large, but some at least must be mentioned here.Banz (1981) and Rienganum (1981) found evidence that the CAPMunderstates cross-sectional average returns of NYSE and AMEX listedfirms with low market values of equity and overstates those of firms withhigh market values of equity. This well-known phenomenon is now gen-erally referred to in the literature as the Small Firm Effect (SFE).Lamoureux and Sanger (1989) find the SFE in NASDAQ traded firms andconclude that the SFE cannot be attributed to market structure differencesbetween the NYSE/AMEX and the NASDAQ. Symmetrically, they con-clude that these markets are not different one from the other. After the2000 melt-down of the dotcoms the Lamoureux and Sanger (ibid.) find-ings were seriously questioned.Nevertheless, evidence contrary to the SFE also exists. Keim (1983) andBrown, Kleidon and Marsh (1983) find instability and reversals in the firmsize anomaly for NYSE/AMEX listed firms. Their results indicate thatfactors other than the relation between a stock's return and overall marketreturns need to be incorporated in modeling firm's expected returns.Other empirical evidence supports the view that the relation between riskand stock returns is captured by some combination of firm specific andmarket specific information.Basu (1983) finds E/P (earning/price) and firm size to be constituents ofaverage returns for NYSE/AMEX listed firms. Nonetheless, Basu also findsbeta, as extracted from the CAPM, to be positively related to returns,indicating that an overall market factor is a component of expected re-turns. In addition to firm size and beta, Bhandari (1988) documents thatleverage, as measured by the total debt-to-equity ratio, is instrumental inexplaining expected stock returns of NYSE/AMEX firms. Chan and Chen(1991) attribute the SFE to the fact that portfolios of small NYSE firmscontain a large proportion of marginal, financially distressed firms. Theyargue that high leverage and reduced dividends explain abnormal returns32 For an extensive list of references of this literature please see Frankfurter (2001).3 The term ‘abnormal return’ comes from the voluminous literature of event studies. Defacto, abnormal returns are nothing else but the arbitrary compilation of error terms from a84 Homo Oeconomicus 24(1) associated with portfolios of small firms.Fama and French (1992) analyze both NYSE/AMEX and NASDAQ traded firms and find that market capitalization and the ratio of the book value of equity to the market value of equity better explain cross-sectional average stock returns than beta, leverage and E/P. They suggest that firm size and the book-to-market equity ratio are useful for extracting market information about risk and expected returns, because they are better proxies of risk. Basu (1983) and Bhandari (1988) also discredit the impor-tance of beta in the explanation of market returns, just as Fama and French (1992) do later.Amihud and Mendelson (1986) develop and empirically verify a ‘liquidity hypothesis’ under which asset returns are positively related to the relative bid-ask spread, which in turn are negatively related to investor liquidity needs. Furthermore, they find the SFE to be a consequence of the spread effect, with firm size functioning as a proxy for liquidity. The sig-nificance of the bid-ask spread and the inconsequence of size reported by Amihud and Mendelson (1989) gives rise to the postulate that excess re-turns of small firms is an illiquidity premium caused by either the lack of investors' interest and/or paucity of publicly available information.Merton (1987) develops a multi-period CAPM that rests upon the as-sumption that market participants require a premium for investing in firms for which little public information is available. This notion, later, is parlayed into the neglect effect, whereas firms’ returns which are not fol-lowed at all, or by a small number of analysts are inferior of those firms that are followed by a large number of analystsInvestor interest and publicly available information may also vary ac-cording to the market in which a firm's stock is traded. Studies of the early 1990’s document significantly higher returns for NYSE/AMEX listed firms than NASDAQ firms (in contrast to Lamoureux and Sanger, 1989, who find no difference between the two markets). One must not wonder, based on 1999’s record braking performance of the NASDAQ how well this, as well as all other, empiricism stands up to time. This is so, because the NASDAQ practically crashed and burned in 2000 barely recovering since.Reinganum (1991) finds the NASDAQ to be more liquid than the NYSE for small firms. Reinganum ascribes the higher return on NYSE small firms to a liquidity premium. Loughran (1993) attributes the differ-ence between firm's returns on the NYSE and the NASDAQ to the poor performance of recent Initial Public Offerings [IPO’s, subsequently] on the NASDAQ, while Fama, French, Booth and Sinquefield (1993) attribute the difference between NYSE/AMEX and NASDAQ traded stocks to higher simple linear regression often called the market model.G.M Frankfurter: Market Efficiency cum Anomolies 85 financial distress for NYSE firms. Overall, these results indicate that theremight be an exchange affect that has to be controlled when studying firmspecific returns.The findings of these effects, as well as other, more exotic effects, suchas the end-of-the-month, – year, Yom Kippur, neglected stocks, etc.,effects that showed the lack of validity of Sharpe’s CAPM were christenedanomalies, a diminutive term that implied a tolerable aberration from aruling belief system. And because according to Fama (1998) the CAPMand the EMH are inseparably linked, the existence of these anomalies, andothers I have not mentioned, are not sufficient to either refute the hy-pothesis or the model.3.… or behavioral financeTwo wrongs don’t make one right, but they make a good excuse.— Thomas SzaszSerious questioning of modern finance as a paradigm started with the im-portation of prospect theory of Kahneman and Tversky (1979) andTversky and Kahneman (1990) into studies of asset pricing. Prospect the-ory is just one alternative to the expected utility maxim (EUM, subse-quently), based on the rationale and untold numbers of experimentalpsychology studies, that the Von Neuman and Morgenstern (1967) [VM,subsequently] axioms upon which EUM builds do not hold. I am espe-cially nonplussed for two reasons:Why only prospect theory, and not other alternative theories of deci-sion making? andHow financial economics was made immune to the rich literature ofother alternatives?Being conspiracy theorists I may be able to answer the second question.An elite who professionally benefited from a positivist way of thinkingkept out the literature critical to the EUM, starting with Allias Paradox(1952), continuing with Rubinstein’s (1988) ‘Similarity,’ and half a dozenother alternative paradigms, not germane to the current issue. I must ad-mit, however, that I have no answer to the first question.3.1OverreactionThe precursor to the over/under –reaction hypothesis of DeBondt andThaler (1985, 1987) is Basu (1978) who reports superior returns of low P/Estocks and inferior returns of high P/E stocks. Basu interprets this findingas inappropriate response to information inconsistent with the EMH that86 Homo Oeconomicus 24(1) is later corrected.Dreman (1979) builds his argument on psychological factors. Accord-ingly, he hypothesizes that investors react to events in a fashion that con-sistently overvalue the prospects of ‘best’ investments and undervalue those they consider the ‘worst.’ Earlier others, (Hickman; 1958, and Atkinson; 1967) find similar reactions to disappointing reports.But the real boost to the overreaction hypothesis comes from DeBondt and Thaler (1985, 1987), as mentioned earlier. Dreman and Berry (1995) summarize the hypothesis’ six predictions:•For long periods ‘best’ stocks underperform while ‘worst’ stocks out-perform the market.•Positive surprises boost ‘worst’ stock prices significantly more than they do the same for ‘best’ stocks.•Negative surprises depress ‘best’ stock prices much more than they do for ‘worst’ stocks.•There are two distinct categories of surprises: event triggers (positive surprises on ‘worst’ stocks, and negative surprises on ‘best’), and re-inforcing events (negative surprises on ‘worst’ stocks and positive sur-prises on ‘best’). Event-triggers result in much larger price movements than do reinforcing events.•The differences will be significant only in the extreme quintiles, with a minimal impact on the 60% of stocks in the middle.•Overreaction occurs before the announcement of earnings or other sur-prises. A correction of the previous overreaction occurs after the sur-prise. ‘Best’ stocks move lower relative to the market, while ‘worst’ stocks move higher, for a relatively long time following a surprise.Dreman and Berry (1995) claim that all six predictions of overreaction show statistical significance.Other overreaction evidence is found in Fama and French (1992), Lakonishok, Shleifer and Vishny (1994), and Loughran and Ritter (1996). Much research of overreaction is in the IPO’s literature of which I care to mention here Loughran and Ritter (1995). In a nutshell, several studies showed the long term performance of IPO’s is below what the market ex-pects it to be at the time of the initial offering. Is it possible that the market is a slow or disadvantaged learner?3.2UnderreactionA number of event studies (yet again!) show evidence of underreaction, just to balance the inefficiency of the market. Obviously, underreaction is the instance where the market, supposedly informationally efficient, doesG.M Frankfurter: Market Efficiency cum Anomolies 87 not react to information in time, or does react in an insufficient manner:too little, too late. Bernard and Thomas (1990) and Abarbanell andBernard (1992) show that financial analysts underreact to earnings an-nouncements, either over or under estimating quarterly earnings afterpositive (negative) surprises. Michaely, Thaler and Womack (1995), findprice responses to dividend cuts and/or initiations to continue for an ex-cessively and irrationally long time. Ikenberry, Lakonishok and Vermaelen(1995) contend that investors underreact to firms’ share repurchases.3.3Contrarians at the gateAll the empirical evidence of the behavioral finance literature gave rise toan investment strategy that systematically exploits the fact that the marketis not as efficient as the high priest and their sycophants, toadies andminions of the EMH want everyone to believe. Perhaps the best-qualifiedspokesperson of the contrarians is David Dreman who not only wrote twobooks on the subject (1979, 1998), but at one time also actively managed$8 billion in assets. Dreman and others believe that they can systematicallyoutperform the market by taking advantage of psychological factors thatmany of the studies I mentioned so far show to exist, and because of whichthe market cannot be efficient. For the contrarians whether the market isefficient or not is an important, yet only a secondary issue. What counts isbeating the market, consistently, a strategy tantamount to not to invest inthe market as a whole, or mimic a popular index.3.4SummaryThe trouble with behavioral finance at its present stage of existence, and asa viable alternative to the EMH, is threefold.•It does not amount to a comprehensive methodology, a clear combina-tion of ontology (what is to be known), and epistemology (how it is tobe known).•Its empirical evidence is almost exclusively event-studies, which I criti-cized elsewhere (Frankfurter and McGoun, 1995), and about whichperhaps the words of the greatest living American philosopher, YogiBerra sound true: I believe it when I believe it.•Its structure, with the exception of some basic assumptions regardinginvestors’ behavior, is the same as the EMH and its aim is the exclusivediscreditation of the EMH. This gives the home court advantage to theEMH, because behavioral finance’s findings can be and often are re-buked by the proponents of the EMH on technical grounds.88 Homo Oeconomicus 24(1)Perhaps, one of these days researchers in finance will wake up and realize that whether markets are efficient or not is not the issue. The issue is to learn more about the decision processes of real investors and find a way to categorize such behavior so later a comprehensive theory could be developed on this foundation.4.Why then anomolies?Out of timber so crooked as that from which man is made,nothing entirely straight can be carved.— Immanuel Kant First, Ball (1996), then Fama (1998) attack behavioral finance, the former with vehemence, and the latter with cunning. Ball (1996) argues that one has to stick with the EMH because (1) we don’t have anything better, (2) it sufficed in the past, and (3) it is now a matter of belief. Certainly, alterna-tives to the EMH are few. Ball can think of only one, which he calls ‘be-havioral finance,’ (ibid., p. 10) referring, principally, to the works of DeBondt and Thaler (1985, 1987). Ball (ibid., pp. 10-11) dismisses this ‘’behavioral’ finance’ on the grounds that:•Investors’ myopia implied by the DeBondt and Thaler work would be ‘grossly inconsistent’ with the notion of competitive markets. (How could one possibly doubt that they are competitive?)•Behavioral finance is also replete with its own anomalies. (Let he who is without sin cast the first stone.)•The claim that ‘efficient marketists’ suppressed evidence contrary to their beliefs is at variance with Ball’s own views and with the fact that ina co-authored work with Brown (Ball and Brown, 1968) they discov-ered ‘post-earnings-announcement ‘drift’ in prices.’ (We have been doing business in the same location for over 40 years. Doesn’t conti-nuity count for something?) (See, Frankfurter and McGoun, 1999).There is no question that the Ball’s second point is well taken. There is no theoretical model that at one point or another in its life-cycle would not have been burdened with exceptions to its rules, or aberrations from its dictum. The first point, however, is wishful thinking, the product of an ideology to which Ball and the Chicago/Rochester School subscribe, and the last point is meaningless.Fama’s (1998) dismissal of ‘behavioral finance’ is far more cleft and crafty. Fama aims with the careful screening of 20 or so papers, mostly from the domain of ‘post-event studies,’ first, to discredit empirical evi-G.M Frankfurter: Market Efficiency cum Anomolies 89 dence. Then, second, that random and conflicting evidence is proof of theexistence of the EMH. Thirdly, that event studies are not merely a method,but a methodology. And lastly, making behavioral finance synonymouswith anomalies.Perhaps this is the most important objective of Fama, because as long aseverything else is just an anomaly the EMH is, practically, irreplaceable.4In essence, when one lumps behavioral finance together with the ‘effects’literature and one calls it anomalies, one creates an unshakable and im-penetrable dogma.5.A paradigm shift?One can live in the shadow of an idea without grasping Elizabeth BowenIs it opportune then to talk about a drastic change of course, what is usuallycalled in the natural sciences, a paradigm shift? An appropriate definition ofparadigm shift is by Colin Bruce.Science is generally supposed to proceed in patient incremental steps. Butjust a few times in the history of science an experiment has produced a result soparadoxical, so difficult to explain in terms of the expected order, that the wholeframework of current assumptions about the world has to be abandoned in fa-vor of a new more subtle picture (Bruce 1998).Accepting Bruce’s definition, it is clear that behavioral finance is noparadigm yet, much less is it a shift. This is so, because when and if onepeels away the surface claim of ‘behavioral’ it is no more than traditional(modern) finance with different assumptions. Although its assumptionsmore realistically describe individual behavior and investment psychologythan modern finance this does not make behavioral finance a paradigm.The objectives, methods and data of research are exactly the same as inmodern finance.Behavioral finance then is neither a new paradigm, nor is it a differentmethodology. Yet, it is call for a cause célèbre. It has the potential to be-come one, if instead of attacking it researchers would be encouraged to de-velop it further, quite possibly importing the methods and proceduresused in related social sciences.There is a lot to learn from psychology, sociology, and anthropology.This learning cannot and will not take place if researchers are not allowedto publish their work, or being warned off because of their way of inquiry.4 Here I should remind the reader that Fama and French (1992) conclude that ‘β has nopredictive power,’ the ultimate failure of a positive model. Yet Fama (1998) makes the pointthat the CAPM and the EMH are inseparably intertwined.90 Homo Oeconomicus 24(1) It would be no one’s loss and perhaps everybody’s benefit if the chance were given to behavioral finance to be fully developed. The same elite that are trying hard to forestall such development should be the first one to recognize this simple truth, if for nothing else but in the name of academic honesty.There are a few positive developments, nevertheless, that may ring in a promising future for behavioral finance. First, there is the fact that the Nobel Prize for economics in 2001 and 2002 went mostly to scholars who were instrumental in creating behavioral economics. As a consequence, behavioral economics, after 20 odd years being in the making, gained le-gitimacy as a subfield. Because financial economics is closely tied to trends in economics, it is reasonable to surmise that behavioral finance will gain legitimacy, as well.A related supporting signal is the existence of a journal that carries the name: The Journal of Behavioral Finance. This is the journal that formerly was known as The Journal of Psychology and Financial Markets. The name change may look mere symbolism, yet there is much more to it than just a new name for an old icon. The fact that the journal is named after a pos-sible subfield of finance is an invitation for research and work that previ-ously couldn’t find a place in the mainstream journals of finance. That is, work that otherwise could survive the scrutiny of academic standards could not be published, because the referees and the political inclination of the journals were not in tune with the findings.In the words of Ludwig Wittgenstein ‘Knowledge is in the end based on acknowledgment.’ Accordingly, research is done first and foremost to be recognized. To be recognized the researcher needs an outlet. This new journal can very well become such an outlet, inspiring more work in the subfield.And lest not forget that it is also tenure and promotion that goes to-gether with recognition. 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