Due to the presence of inefficiency within the global market, the sales and profitability of a company is not only affected but also the country’s ability to build a more reliable capital asset. Therefore, in response to poor market efficiency, the study on behavioural finance has gained importance back in 1990s2. Using knowledge on behavioural finance, the main causes and underlying drivers of the most recent global financial crisis will be identified and tackled in details. As part of analyzing the factors that has triggered the recent global financial crisis, both behavioural and non-behavioural explanation behind such crisis will be compared and contrast. In relation to the presence of irregularities in the global markets, whether or not “value” is riskier than “growth” will be answered based on the theory behind the rational risk pricing. 2. Main Causes and Underlying Drivers of the Most Recent Global Financial Crisis 2.1 Non-behavioural Explanation behind the Most Recent Global Financial Crisis Next to the Great Depression which occurred back in 1930s, the worst global financial crisis happened between 2007 to 2008 when most of the large-scale financial institutions worldwide were at risks of bankruptcy aside from the sudden fall in the stock markets3. Specifically the U.S. ...Show more
Behavioural Finance and Market Efficiency Total Number of Words: 2,998 1. Introduction Since 1990s, the study of behavioural finance and market efficiency often goes hand in hand. In most cases, inefficient market can lead to the development of economic recession…
In the past, there have been several market bubbles followed subsequently by market crashes, some of which include the Tulip mania in the 17th century, the great market crash of 1929, the dot com mania of the late 1990s, and the recent sub-prime mortgages and the Collateral Debt Obligations crisis.
Why? Financial markets are very competitive and research studies note that there are little or no externalities from those participating in the market. Given such conditions, a rational investor has high chances of recording collectively efficient outcomes from investment decisions.
It commenced from the United States’ subprime mortgage market and spread across global, financial markets (Gonzalez-Hermosillo, 2008, p, 3). Conditions in global, financial markets affect international investors’ risk appetite. Changes in international investors’ risk appetite may be responsible for the spread of the original shock across, global, financial markets (Gonzalez-Hermosillo, 2008, p, 3).
As opposed to traditional finance, whose underlying assumption is that investors are "rational" beings; this rationality tries to point out that as the fund managers receive information they react spontaneously and update their briefs as soon as possible and also explains that given their briefs they make choices that are normatively acceptable1.
Fama [Eugene Fama, University of Chicago] says behavioural economists made the same mistake in reverse: 'The fact some individuals might be irrational doesn't mean the market is inefficient.'"
To understand Shiller and Fama better and help us critically evaluate the rationality of their arguments and conclusions, we need to explain their different assumptions and how they arrived at their conclusions.
If prices develop in a predictable manner, arbitrageurs would discern the trends, act on them, and make money at a rate above normal market returns and their actions would quickly bring stock prices to their intrinsic values.
This set of assumptions is defined by the Efficient Market Hypothesis (EMH) studied by Fama (1970).
The growth and development of the theories and models of this special area of finance has led to new development in the stock market. Though, individual investors form an insignificant portion of the total stock market investment, the behaviour exhibited by them can have great influence on the performance of the stock market and trading.
The author explains how behavioural finance can explain the anomalies which have persisted too long to lead to this crisis situation. He states that The efficient market hypothesis is based on the Random Walk Hypothesis, which states that the changes in a stock’s price are a random departure from its previous price.