Arguments of Two Nobel Laureates- Eugene Fama and Richard Thaler

Recently, investing in the financial markets has become popular among individual investors and financial institutions. Bikas, Jurevičienė, Dubinskas, and Novickytė (2013) opine that information and communication have become ubiquitous globally thereby accessible within seconds. As such, investment decisions are based on the publicly available information, participant’s logic and sometimes emotions. Efficient Market Hypothesis (EMH) and behavioral finance exemplify divergent schools of thoughts that endeavor to elucidate on investor behavior. Put forth by 2013 Nobel Prize Laureate in Economics, Eugene Fama captured the core points of the modern portfolio theory. Feinstein (2000) presents that the EMH is one of the foundations of the contemporary financial economics. The model presents that information is swiftly as well as proficiently integrated into the assets prices rendering the old information invaluable in foretelling the future price movements. Fama claims “the financial markets are efficient, investors make rational decisions, market participants are sophisticated, informed and only act on available information” (Ţiţan, 2015). On the other hand, Richard Thaler’s behavioral finance perspective combines behavioral psychology with conventional finance and economics to explain why people make irrational behaviors (Chaudhary, 2013). Simply put, the 2017 winner of Nobel Prize in Economics recognizes that in most cases, decisions made by investors are inconsistent and cognitive illusions play a critical role in human decisions.

Conceivably, the easiest means to consider their opinions and positions are through bearing in mind the implications of each continuum. As such, the EMH considers how the financial market works in the ideal world whereas behavioral finance delves at how the financial markets operate in the real world. For the equity fund, the solid understanding of both perspectives can be fundamental in making better investment decisions. This paper discusses the perspectives of Eugene Fama and Richard Thaler regarding market efficiency and behavioral finance respectively and notes the possible implications of their views to the equity fund.

Discussion of Fama’s Views

Eugene Fama is a professor at the University of Chicago and was among three economists to be awarded the 2013 Nobel Prize in Economic Sciences. The award is a recognition of his ground-breaking work regarding the Efficient Market Hypotheses. Fama demonstrates that the stock prices are exceedingly challenging to forecast in the short-term. Similarly, he presents that information is rapidly integrated into stock prices. The rationale behind this perspective is that there are well-informed professionals working in the financial markets that form an efficient system. Therefore, securities are assigned the ideal price based on the existing information (Beechey, Gruen & Vickery, 2000). In this regard, Fama claims that when the flow of information is unhampered and is instantly reproduced on the stock prices, then a price adjustment is reflective of only the available news. Information is considered unpredictable thereby making the price changes unpredictable as well as random.

According to Gupta, Preetibedi, and Mlakra (2014), economists do not permit an investor to make above-average proceeds devoid of tolerating the above-average risks. On the same note, Fama’s view advocates that the financial markets efficiency should be based on overwhelming information, news as well as any communication involved. Fama (1970) describes an efficient marketplace as one where “there are large numbers 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” (Sudarisman & Lubis, 2017). This means that the aggregate stock market is characterized by efficiency with the replication of prevailing information on the current stock prices. One real world example relates to when the US treasury bonds were downgraded. It was easy for an investor to assume that their prices would have drop substantially. However, the opposite happened and every investor raised their value at the treasury. As such, the event confirms Fama’s view that it is very difficult to consistently make predictions in the financial markets. However, many analysts are critical of this belief. They claim that instant prices do not always lead to an efficient market. The October 2009 volatility in IBM stock provides an ideal example that a quick response does not always lead to effective price change. The corporation publicized quarterly returns of $2.40 per share. Financial analysts had forecasted $2.38 making it 2 cents better than the forecasts (Thomsett, 2018). While IBM stock rose to $3.58, the next day saw a fall of $6.34.

Fama characterizes market efficiency into three different forms which are weak, semi-strong and strong forms of efficient market efficiency (Harder, 2008). The weak form of EMH denotes that information is beyond trading volumes and prices. This means that the past stock information is integrated into the current prices. Consequently, they cannot be utilized to predict the future. Whereas this type of EMH has the strongest support, it is the least significant considering that investors often have more than the past trading data (Schubert, 2009). In semi-strong form, Fama presents that the required information is the one that is publicly available. For investors, this is the information that they can be accessed such as assets, balance sheets and announcements of listed firms. This means that if it holds, it is useless to analyze stock to separate winners from losers. The strong EMF version is based on all information available such as private, public and even confidential. The strong form does not allow investors to attain a competitive edge in the course of the investment.

According to Fama, investors cannot outperform markets which means they cannot realize high returns when information is exclusive to every investor. Besides, any new information cannot draw anomalous proceeds since it is directly accessible to everyone and is replicated in stock prices (Sewell, 2011). Fama posits that the competition in an efficient market causes the impact of fresh information on the inherent values to be replicated instantaneously to the actual prices. Overall, the EMH shows that the fundamental analysis of a firm’s stock is conducive to stock evaluation as opposed to the prediction or future movements. Still, Fama’s view is that technical analysis cannot be utilized to encounter imminent fluctuations over time. However, several fund managers such as Warren Buffet have challenged the efficiency of the market (Heakal, 2013). Buffet’s investment strategy that focusses on undervalued stock earned him billions of proceeds. It means that there are portfolio managers with better track records than others. Besides, it shows that there are investment firms with better research analysis than others which is against Fama’s views,

For investors, the implication of efficient market hypothesis according to Fama is that when speculative trading is expensive, the speculation becomes a loser’s game. In this regard, the indexing strategy is more likely to concur the approach that uses active management (Ang, Goetzmann & Schaefer, 2010). In this case, the active management is one that intends to make the most of mispriced assets because the market moves faster than any individual agent.

Discussion of Thaler’s Views

Richard Thaler is an American economist and the winner of the 2017 Noble Price for Economics owing to his contributions to behavioral economics. In fact, he is considered as “the father of behavioral economics.” Over the years, he has been a key proponent of the idea that humans cannot be entirely rational. In his published works that spans more than four decades, Thaler notes that economic decision-making can be significantly and systematically influenced by the natural cognitive biases among other psychological aspects (Malkiel, Mullainathan & Stangle, 2005). Besides, his incorporation of psychology into economic analysis has availed a comprehensive analytical and experimental tool for understanding human behavior. As such, his views consistently refute claims that investors often act rationally and selfishly (Chaudhary, 2013). Importantly, Thaler’s identification of various ways where investors real economic behavior deviates from rational conventions has significant practical implications to the equity fund. The firm’s policies can be made effective through the incorporation of subtle inducements to drive individuals towards good decision making. Katsuhiko Okanda, the CEO of Magne-Max Capital Management employs behavioral finance in making investment pronouncements. He asserts “In order to successfully apply behavioral finance to money management, an interdisciplinary system development is a must” (Kuo, 2013). This shows that behavioral finance is becoming increasingly adopted by investment firms.

Thaler’s focus is on how investors deduce and act on the available facts to make cognizant choices. He presents that investors do not often act in a predictable, rational and in an impartial way (Barberis & Thaler, 2003). Among the non-rational influences on economic behavior, Thaler identified bounded rationality. He notes that investors simplify decision-making through the creation of separate accounts in their minds with the emphasis on the distinct decision rather than the overall effect. The limited rationality produces outcomes that are generally satisfactory although less than optimal in some instances (Frankfurter & McGoun, 2010). For instance, the phenomenon of ‘mental accounting’ ensures individual mentally divide their expenditures into different classes or accounts (Chaudhary, 2013). These can be a mortgage, food, entertainment, clothing and home maintenance. In this regard, Thaler notes that the decisions are based on the effects of the pertinent accounts. Besides, his account of loss aversion explains why individuals tend to value the same item more than when they actually own it.

Thaler notes that there are self-control challenges that tend to prevent the execution of optimal plans even after they are computed. According to Sudarisman and Lubis (2017), such aspects influence trading by making the investor’s behavior irrational. Thaler notes that an individual tends to be a myopic doer who assesses alternatives purely for their current utility (Johnsson, Lindblom & Platan, 2002). Moreover, he presents that there is a far-sighted planner who is an individual that is only concerned with the lifetime utility. This perspective by Thaler is applied to understand individual’s savings behavior as well as households (Jahanzeb & Muneer, 2012). Along with the model of limited cognition, self-cognition has been influential in policy formulation.

It is worth mentioning Thaler’s view regarding the influence of social preference in economic decision-making. There are many situations where it can be assumed that individuals behave based on their own self-interests (Byrne & Brooks, 2008). Nonetheless, there are equally more socially inclined motivations such as the desire for equity and fairness that influences decision-making. Thaler even provides an empirical evidence to support the claim that fairness is a significant element for consumer decision making.

Thaler’s views within the broader behavioral finance have various implications on the investment decisions that can be of importance to the equity fund (Ţiţan, 2015). Intrinsically, his contribution to behavioral finance provides insights on how investors make common errors pertaining to their financial decisions because of emotions. Investors are often embroiled in decision-making processes where they have to choose between several alternatives (Byrne & Utkus, 2013). As such, Thaler recognizes that investors are often rational beings with the objective of maximizing their financial gain. Thus, they can sometimes make dumb investment decisions. In this regard, the key to becoming a better financial decision maker is becoming aware of as well as the avoidance of certain types of behaviors. The understanding of Thaler’s insinuations and behavioral science in general, an individual the likely damage from errors resulting from limited rationality, lack of self-control and social preferences.

Conclusion and Recommendations

Two prominent and Nobel Prize winners, Eugene Fama and Richard Thaler represent market efficiency and behavioral finance school of thoughts respectively. For decades, the idea that the financial markets are efficient and that stock market prices are a reflection of the publicly available information has subjugated the academic thinking. Nonetheless, the bubble of the 1990s along with the advancement of behavioral finance has reshaped the consideration. Fama argues that the financial markets are efficient with investors who are rational decision-makers and sophisticated, well-informed market participants acting only on available information. Considering that every market participant has the access to the same facts, all securities are aptly valued at a given interval. On the other hand, behaviorists like Thaler argue that even with neat models and market sophistication, stocks will often trade at inexcusable prices because individuals make illogical decisions. As such, Thaler postulate that psychology and emotions play a critical part in investor’s decisions. The consequence is that they go ahead to behave in unpredictable ways owing to lack of self-control, mental accounting and social preferences among other psychological factors.

The equity fund should not misinterpret the efficient market hypothesis by considering that there is no such a thing as investment portfolio design. It should be noted that there are significant decisions that should be made to obtain a portfolio with a suitable risk. The expected rewards for the risk as well as probable costs should equally be evaluated. However, the equity fund can employ efficient market theory as one of its pillars in making investment decisions. On the same note, the firm should consider that behavioral finance is equally significant in the decision-making process since it greatly influences the investor's performance. Taking note of behavioral finance and Thaler’s views, in particular, will help in the selection of better investments instruments. Besides, the insights can help to avoid the repetition of expensive errors in the future. After all, the significance of behavioral finance lies in the minimization of psychological influences in investment decisions.

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