8/3/2019 Issue 1 n 2-Biwesh

1/3

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 Statman2,

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

1

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

3 Fama, Eugene F., "Efficient Capital Market: II", The journal of Finance, Vol XLVI, no. 5, December1991

8/3/2019 Issue 1 n 2-Biwesh

2/3

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 theirrational 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 theinvestors 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, CEPSWorking 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

http://people.stern.nyu.edu/adamodar/New_Home_Page/invemgmt/effdefn.htmhttp://people.stern.nyu.edu/adamodar/New_Home_Page/invemgmt/effdefn.htm

8/3/2019 Issue 1 n 2-Biwesh

3/3

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 oftransaction 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",