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www.accedoverlag.de

Homo Oeconomicus 24(1): 8193 (2007)

Market Efficiency cum Anomalies,or Behavioral Finance?

George M. Frankfurter

Lloyd F. Collette professor Emeritus at Louisiana State University, Baton Rouge, USA(eMail: [email protected])

Abstract The efficient markets hypothesis of Fama and the capital asset pricing

model of Sharpe constitute the paradigm of what is often called modern nance.Although early, joint tests of both the hypothesis and the model showed the signsof existence, serious doubts started to surface with the large-scale discovery ofeffects, 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 Tverskyfound its way to the nancial 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 nance. Yet, the acionados of modern

nance call the empirical ndings of behavioral nance as another set of anoma-lies. This paper is about the differences between modern and behavioral nance,and how the proponents of the former try to perpetuate their theory by referring tothe latter as anomalies.

Keywords market efficiency, behavioural nance, nancial economics paradigm, modern

nance

We have rst raised a dust then complain we cannot see.

Bishop Bradley, Principles of Human Knowledge.

1. IntroductionFamas Efficient Capital Markets: A Review of Theory and EmpiricalWork saw the light of publication (Fama, 1970) in 1970. The paper re-dened his earlier allusion to capital markets efficiency (Fama, 1965) andsimply argued that in an efficient market prices reect all what there is toknow about a capital asset. Later, Famas efficient market hypothesis[EMH, subsequently] was endowed with three distinct forms of infor-

2007 Accedo Verlagsgesellschaft, Mnchen.

ISBN 3-89265-064-0 ISSN 0943-0180

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82 Homo Oeconomicus 24(1)

mational efficiency, namely, the weak, the semi-strong, and the strongforms.1

Although the exact origins of these three forms are not explicitlyknown, or traceable, it is generally held that:

the weak form implies a random walk of some form (part of Famas1965 denition of efficiency), and that one cannot take advantage of theknowledge of historical price movements,

the semi-strong form implies that prices at any given time incorporateall publicly available information, and

the strong form implies that prices at any given time incorporate allin-formation, whether public or private.

The EMH revolutionized beliefs about the pricing and the operation ofcapital markets, because it was in line with an ideology that markets,whether capital or otherwise, know best. Accordingly, one must concludethat as a social policy, the best government can do is not to interfere withsuch 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 thecapital asset pricing model [CAPM, subsequently] of Sharpe described theoperation and the characteristics of capital markets. That is, markets notjust for stocks but all capital assets. Regardless, all subsequent tests of boththe model and the hypothesis were done on a universe, some times evenlimited universe, of common stocks.

In this paper I am discussing how doubts about both the model and thehypothesis surfaced, how the believers in the model have been trying toght 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 thesense that the latter provided a means for testing the former. This syn-thesis opened a door for empirical validation of both the hypothesis and

1There 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.

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G.M Frankfurter: Market Efficiency cum Anomolies 83

the pricing model. Through this door, or rather oodgate, 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 couldnt be rejected, based on the data thatwere available at the time.2

Yet, 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 reected 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 CAPM

understates cross-sectional average returns of NYSE and AMEX listedrms with low market values of equity and overstates those of rms 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) nd the SFE in NASDAQ traded rms 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.) nd-ings were seriously questioned.

Nevertheless, evidence contrary to the SFE also exists. Keim (1983) andBrown, Kleidon and Marsh (1983) nd instability and reversals in the rmsize anomaly for NYSE/AMEX listed rms. Their results indicate thatfactors other than the relation between a stock's return and overall marketreturns need to be incorporated in modeling rm's expected returns.Other empirical evidence supports the view that the relation between riskand stock returns is captured by some combination of rm specic andmarket specic information.

Basu (1983) nds E/P (earning/price) and rm size to be constituents ofaverage returns for NYSE/AMEX listed rms. Nonetheless, Basu also ndsbeta, 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 rm 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 rms. Chan and Chen

(1991) attribute the SFE to the fact that portfolios of small NYSE rmscontain a large proportion of marginal, nancially distressed rms. Theyargue that high leverage and reduced dividends explain abnormal returns3

2For an extensive list of references of this literature please see Frankfurter (2001).3The term abnormal return comes from the voluminous literature of event studies. De

facto, abnormal returns are nothing else but the arbitrary compilation of error terms from a

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associated with portfolios of small rms.Fama and French (1992) analyze both NYSE/AMEX and NASDAQ

traded rms and nd that market capitalization and the ratio of the bookvalue of equity to the market value of equity better explain cross-sectionalaverage stock returns than beta, leverage and E/P. They suggest that rmsize and the book-to-market equity ratio are useful for extracting marketinformation about risk and expected returns, because they are betterproxies of risk. Basu (1983) and Bhandari (1988) also discredit the impor-tance of beta in the explanation of market returns, just as Fama andFrench (1992) do later.

Amihud and Mendelson (1986) develop and empirically verify aliquidity hypothesis under which asset returns are positively related to therelative bid-ask spread, which in turn are negatively related to investorliquidity needs. Furthermore, they nd the SFE to be a consequence of thespread effect, with rm size functioning as a proxy for liquidity. The sig-nicance of the bid-ask spread and the inconsequence of size reported byAmihud and Mendelson (1989) gives rise to the postulate that excess re-turns of small rms is an illiquidity premium caused by either the lack ofinvestors' 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 inrms for which little public information is available. This notion, later, isparlayed into the neglect effect, whereas rms returns which are not fol-lowed at all, or by a small number of analysts are inferior of those rmsthat are followed by a large number of analysts

Investor interest and publicly available information may also vary ac-cording to the market in which a rm's stock is traded. Studies of the early1990s document signicantly higher returns for NYSE/AMEX listed rmsthan NASDAQ rms (in contrast to Lamoureux and Sanger, 1989, whond no difference between the two markets). One must not wonder, basedon 1999s record braking performance of the NASDAQ how well this, aswell as all other, empiricism stands up to time. This is so, because theNASDAQ practically crashed and burned in 2000 barely recovering since.

Reinganum (1991) nds the NASDAQ to be more liquid than theNYSE for small rms. Reinganum ascribes the higher return on NYSE

small rms to a liquidity premium. Loughran (1993) attributes the differ-ence between rm's returns on the NYSE and the NASDAQ to the poorperformance of recent Initial Public Offerings [IPOs, subsequently] on theNASDAQ, while Fama, French, Booth and Sinqueeld (1993) attribute thedifference between NYSE/AMEX and NASDAQ traded stocks to higher

simple linear regression often called the market model.

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nancial distress for NYSE rms. Overall, these results indicate that theremight be an exchange affect that has to be controlled when studying rmspecic returns.

The ndings 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 Sharpes 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 nanceTwo wrongs dont make one right, but they make a good excuse.

Thomas Szasz

Serious questioning of modern nance 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 experimental

psychology 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? and

How nancial 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 beneted from a positivist way of thinkingkept out the literature critical to the EUM, starting with Allias Paradox(1952), continuing with Rubinsteins (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 rst question.

3.1 OverreactionThe 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 ndingas inappropriate response to information inconsistent with the EMH that

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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 undervaluethose they consider the worst. Earlier others, (Hickman; 1958, andAtkinson; 1967) nd similar reactions to disappointing reports.

But the real boost to the overreaction hypothesis comes from DeBondtand 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 signicantly more than theydo the same for best stocks.

Negative surprises depress best stock prices much more than they dofor worst stocks.

There are two distinct categories of surprises: event triggers (positivesurprises 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 movementsthan do reinforcing events.

The differences will be signicant only in the extreme quintiles, with aminimal 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 worststocks move higher, for a relatively long time following a surprise.

Dreman and Berry (1995) claim that all six predictions of overreactionshow statistical signicance.

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 IPOs literature of which I care tomention here Loughran and Ritter (1995). In a nutshell, several studiesshowed the long term performance of IPOs is below what the market ex-

pects it to be at the time of the initial offering. Is it possible that the marketis a slow or disadvantaged learner?

3.2 UnderreactionA number of event studies (yet again!) show evidence of underreaction,just to balance the inefficiency of the market. Obviously, underreaction isthe instance where the market, supposedly informationally efficient, does

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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 nancial analysts underreact to earnings an-nouncements, either over or under estimating quarterly earnings afterpositive (negative) surprises. Michaely, Thaler and Womack (1995), ndprice 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 rms share repurchases.

3.3 Contrarians at the gateAll the empirical evidence of the behavioral nance 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-qualiedspokesperson 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.

3.4 SummaryThe trouble with behavioral nance 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 which

perhaps 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 nances ndings can be and often are re-buked by the proponents of the EMH on technical grounds.

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Perhaps, one of these days researchers in nance will wake up andrealize that whether markets are efficient or not is not the issue. The issueis to learn more about the decision processes of real investors and nd away to categorize such behavior so later a comprehensive theory could bedeveloped 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 nance, the formerwith vehemence, and the latter with cunning. Ball (1996) argues that onehas to stick with the EMH because (1) we dont have anything better, (2) itsufficed 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 nance, (ibid., p. 10) referring, principally, to the works ofDeBondt and Thaler (1985, 1987). Ball (ibid., pp. 10-11) dismisses thisbehavioral nance on the grounds that:

Investors myopia implied by the DeBondt and Thaler work would begrossly inconsistent with the notion of competitive markets. (Howcould one possibly doubt that they are competitive?)

Behavioral nance is also replete with its own anomalies. (Let he who iswithout sin cast the rst stone.)

The claim that efficient marketists suppressed evidence contrary totheir beliefs is at variance with Balls own viewsand 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 beendoing business in the same location for over 40 years. Doesnt conti-nuity count for something?) (See, Frankfurter and McGoun, 1999).

There is no question that the Balls second point is well taken. There is

no theoretical model that at one point or another in its life-cycle would nothave been burdened with exceptions to its rules, or aberrations from itsdictum. The rst point, however, is wishful thinking, the product of anideology to which Ball and the Chicago/Rochester School subscribe, andthe last point is meaningless.

Famas (1998) dismissal of behavioral nance is far more cleft andcrafty. Fama aims with the careful screening of 20 or so papers, mostlyfrom the domain of post-event studies, rst, to discredit empirical evi-

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dence. Then, second, that random and conicting evidence is proof of theexistence of the EMH. Thirdly, that event studies are not merely a method,but a methodology. And lastly, making behavioral nance 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 nance together with the effectsliterature 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 Bowen

Is it opportune then to talk about a drastic change of course, what is usuallycalled in the natural sciences, a paradigm shift? An appropriate denition 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 Bruces denition, it is clear that behavioral nance 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) nance with different assumptions. Although its assumptionsmore realistically describe individual behavior and investment psychologythan modern nance this does not make behavioral nance a paradigm.The objectives, methods and data of research are exactly the same as inmodern nance.

Behavioral nance then is neither a new paradigm, nor is it a differentmethodology. Yet, it is call for a cause clbre. 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.

4Here I should remind the reader that Fama and French (1992) conclude that has no

predictive power, the ultimate failure of a positive model. Yet Fama (1998) makes the point

that the CAPM and the EMH are inseparably intertwined.

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It would be no ones loss and perhaps everybodys benet if the chancewere given to behavioral nance to be fully developed. The same elite thatare trying hard to forestall such development should be the rst one torecognize this simple truth, if for nothing else but in the name of academichonesty.

There are a few positive developments, nevertheless, that may ring in apromising future for behavioral nance. First, there is the fact that theNobel Prize for economics in 2001 and 2002 went mostly to scholars whowere instrumental in creating behavioral economics. As a consequence,behavioral economics, after 20 odd years being in the making, gained le-

gitimacy as a subeld. Because nancial economics is closely tied to trendsin economics, it is reasonable to surmise that behavioral nance will gainlegitimacy, as well.

A related supporting signal is the existence of a journal that carries thename: The Journal of Behavioral Finance. This is the journal that formerlywas known as The Journal of Psychology and Financial Markets. The namechange may look mere symbolism, yet there is much more to it than just anew name for an old icon. The fact that the journal is named after a pos-sible subeld of nance is an invitation for research and work that previ-ously couldnt nd a place in the mainstream journals of nance. That is,work that otherwise could survive the scrutiny of academic standardscould not be published, because the referees and the political inclination ofthe journals were not in tune with the ndings.

In the words of Ludwig Wittgenstein Knowledge is in the end based onacknowledgment. Accordingly, research is done rst and foremost to berecognized. To be recognized the researcher needs an outlet. This newjournal can very well become such an outlet, inspiring more work in thesubeld.

And lest not forget that it is also tenure and promotion that goes to-gether with recognition. Faculty, especially, young and more productivefaculty will not start work where the possibility of publication, even as justa promise, does not exist.

Finally, being the eternal optimist by nature, I most sincerely believethat a reality retardant theory cannot survive ad innitum, and a new gen-eration of academics will emerge from the failures of the old elite.

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