Of Reason and Reasons

Group 5: Biwesh Neupane, Dev Raj Dhungana, Mingma Sherpa Lama, Shrawan Regmi Case Synopsis Case Summary 1. Is it necessary for investors to be rational for markets to be efficient? To answer this question let us first define what efficient market is and who rational investors are. Efficient market as defined by Eugene Fama1 "An 'efficient' market is defined as a market where there are large number of rational, profit maximizers actively competing, with each trying to predict future market values of individual securities, and where important current information is almost freely available to all participants". Thus, efficient market is one where the market price is an unbiased estimate of the true value of the investment. In other words, the market efficiently processed the information contained in past prices. Thus, in an efficient market: everything that can be known about a stock has already been incorporated into the price of that stock, hence, at any point in time the actual price of a security will be a good estimate of its intrinsic value it is impossible to do better than the market over the long term

Rational investors are those who are constantly reading the news and react quickly to any new significant information about a security. According to Meir Statman 2, People are rational in standard finance; they are normal in behavioral finance. Rational people care about utilitarian characteristics, but not value expressive ones, are never confused by cognitive errors, have perfect self-control, are always averse to risk, and are never averse to regret. Normal people do not obediently follow that pattern. According to Eugene Fama himself, the extreme version of market efficiency hypothesis is surely false, because of the presence of positive information and trading costs3. A market efficiency hypothesis does not necessarily mean that all

2 Statman, Meir (1999), Behavioral Finance: Past Battles, Future Engagements, Financial Analysts
Journal, vol. 55, no. 6 (November/December), 18-27 1991

3 Fama, Eugene F., "Efficient Capital Market: II", The journal of Finance, Vol XLVI, no. 5, December

the investors should be rational. According to Burton G. Meilkeil4, "Markets can be efficient even if many market participants are quite irrational." Markets can be efficient even if stock prices exhibit greater volatility than can apparently be explained by fundamentals such as earnings and dividends. Even if there are few irrational investors, if the rational investors outweigh the irrational investors, the stock market will be fairly closely towards the intrinsic value. Efficient market hypothesis also assumes that if stock prices deviate from their intrinsic values, rational investors will quickly take advantage of this mispricing by buying undervalued stocks and selling overvalued stock. This action moves the current stock price to new market equilibrium based on new information. Even if some investors behave irrationally, by holding the losing stocks too long and/or selling the winning stocks too quickly, it does not mean that market is not efficient. Thus, without rational market, there cannot be an efficient market. But the presence of irrational investors does not disprove the presence of efficient market. Hence, it is possible to have irrational investors in efficient market. 1. Under what conditions does irrationality among investors yield opportunities for beating the market? According to A. Damodaran5, even in efficient market, approximately half of the investors, prior to transaction costs, should beat the market in any time. Likewise he believes that a fairly large number are going to beat the market consistently over long periods, not because of their investment strategies but because they are lucky. Efficient market hypothesis does not claim that investors are unable to outperform or beat the market; rather, it is possible to for an investor to earn above average return if newly released information causes the price of the security the investors own to substantially increase. What efficient market hypothesis does claim is that one should not be expected to outperform or beat the market predictably or consistently. Due to the presence of rational investors, the efficient market prevails. Even though it is generally believed that in efficient market one cannot beat the market, it is also accepted that investors can indeed gain above average return than others. Some economists term this as a pure mathematical luck, whereas, other believes it is because of the presence of irrational investors that some investors like Buffet, Peter Lynch and other investment funds gain above average market return. It is the actually in long run that rational investors can make profit. Irrational investors
4 Malkiel, Burton G., "The efficient market hypothesis and its critics", Princeton University, CEPS
Working Paper No.91, April 2003

5 Damodaran, Aswath. "Market Efficiency Definition and Tests", Stern School of Business, New York University, Damodaran Online: http://people.stern.nyu.edu/adamodar/New_Home_Page/invemgmt/effdefn.htm

generally hold losing shares too long in a hope that it will bounce back and sell winners too quickly in excitement. It is act of the irrational investors in short run that rational investor gain in long run. In mid 1999, when NASDAQ was trading at 3000, rational investors concluded that it was overvalued. But because of the act of irrational investors NASDAQ soared to over 5000. However, rational investors gained later when NASDAQ dipped down to 1300.6 The next condition is the processing and understanding of information. Even though both investors process information, the way rational investor process the information may be different than the way irrational investor process the information. Moreover, irrational investors may not have full access to the relevant information and may not sense the information in an optimal way, which rational investors usually do. The more different the perception of information is, the more the opportunity for rational investors to beat the market. Another condition may be that rational investors can beat the market if the value of transaction conducted by the irrational investors is greater than the value of transaction conducted by the rational investors. The number here does not make sense because the market may behave efficiently if the huge number of irrational investors take passive strategies and does not involve in trade. Market can be efficient even if relatively small core of informed and skilled investors trade in the market. However, if there is a relatively huge transaction done by irrational investors, the stock price may not depict the intrinsic value of the stock. In such case, rational investors can determine the undervalued and overvalued stock and trade on the stock to get above average return. But with greater transaction, the price will eventually move towards the new equilibrium reflecting the new information. For a time being, the rational market can beat the market. Conclusion

6 Eugene F. Brigham, Michael C. Ehrhardt, "Financial Management Theory and Practice",