In his publications, Robert Shiller has critiqued the Efficient Market Hypothesis.
In the publication “From Efficient Markets Theory to Behavioral Finance,” Shiller (2003) argues that previously, the Efficient Market Theory was considered as the only one accurately explaining how the market operates. However, with the introduction of Behavioral Finance, the Efficient Market Theory has undergone a series of criticism. The main argument Shiller (2003) presents to critique the Efficient Market Theory is the excess volatility of the US markets. This paper will provide a critical explanation of the excess volatility hypothesis and explain whether it undermines the Efficient Market Theory.
Shiller’s work is one of the most well-recognized theoretical explanations of market volatility and its effect on the decision-making of consumers. According to Barrett (n.d.), among the most relevant literature on the volatility issue is Robert Shiller’s “Market Volatility,” which shows that he is a strong supporter of the prevalent model of stock market volatility. Other models used by financial specialists provide a qualitative explanation for price changes.
However, Shiller’s approach contends that investor emotions based on psychological or sociological ideas have a stronger effect on the market than sound economic sense reasoning (Barrett, n.d.). This is consistent with Shiller’s (2003) recognition of the importance that Behavioral Finance has when explaining the changes within the financial markets as opposed to traditional theories that are based on rational decision-making. Still, based on Shiller’s work, the author does not completely dismiss the work of economists who support the Efficient Market Hypothesis. Hence, one can argue that this theory provides some valid explanations of market behaviors but does not address all the factors impacting stock prices. In Shiller’s view (2003), the Efficient Market Theory can be supported by statistical evidence, but he argues that investor sentiments have a significant role in influencing price levels. Hence, Shiller suggests reviewing other factors, apart from rational decision-making and statistical data, that might affect the people who are engaged in financial markets.
Shiller supports his excess volatility hypothesis with statistical data. The author’s book presents statistical evidence that there is excess volatility in the stock market, implying that volatility cannot be fully explained by the Efficient Market Theory as the application of this theory cannot explain these changes (Shiller, 2003). Thus, the main critique of the Efficient Market Theory is that it does not explain all occurrences in the market. The term “excess volatility” refers to volatility that exceeds the amount expected by Efficient Market theorists (Shiller, 2003). According to Shiller (2003), “excess volatility” might be related to investors’ psychological behavior, and significant price fluctuations may be explained by the investing public’s collective change of mind, which can only be described by its ideas and beliefs about future occurrences. Essentially, this approach means that there is excess volatility in the market that the Efficient Market theorists cannot explain, and one way of addressing this is through other theories, for example, by evaluating the expectations of the investors.
One issue with this argument is that the decisions of individuals can be explained rationally as they are based on some expectations and information these individuals possess. According to Shiller (2003), the existing models’ hypothesis posits that individuals react improperly to information they receive, and as a result, contrary to what the Efficient Market Theory would suggest, openly available information is not always already included in stock market prices. Thus, investor behavior is influenced by ex-post values, which are the prices of an asset after deducting future dividends (Barrett, n.d.). Ex-post values, on the other hand, cannot be determined ahead of dividend payment; thus, if future payouts are predicted to be large, the ex-post value today will likewise be high. Barrett (n.d.) states that under the Efficient Market Theory, the ex-post values would be determined by the following formula, where Pt represents the ex-post value: Pt = EtPt*
Within this formula, pricing equals the best feasible ex-post projection or anticipation (Barrett, n.d.). However, capital gains or losses in a share do not influence ex-post values because true ex-post values only represent the payoffs generated by the investment itself. If an efficient market exists, these gains and losses are simply due to changes in knowledge regarding ex-post values. If the Efficient Market Theory fails to address these issues, these gains or losses may have nothing to do with ex-post valuations and may be a reaction to the activities of other investors. According to efficient market theorists, the Efficient Market Theory may be used to explain price fluctuations (Barrett, n.d.). For example, fresh dividend information might be published. However, in reality, these changes are too large to be explained by changes in information. Shiller (2003) provides statistical evidence to imply that dividend variations, which determine ex-post value, would have to be rather significant to explain this volatility adequately. Hence, Shiller’s argument highlights the insufficiencies of the Efficient Market Theory since this theory fails to explain excess volatility.
The traditional approach would mean that the volatility is caused by changes in dividends. However, Shiller (2003) provides statistical data to imply that variations in dividends, which determine ex-post value, would have to be considered both in terms of size and length of a trend to mimic price fluctuations. This has happened before, however, only once, and other cases of excess volatility are not linked to such considerable changes. Shiller (2003) states that dividends were only considerably below their IR growth trend for four years during the Great Depression of the 1930s. Hence, there should be other factors that explain the excess volatility in the financial markets.
Based on the excess volatility approach, Behavioral Finance theory appears to explain the stock market’s price changes more efficiently. According to Shiller (2003), behavioral finance is “finance from a broader social science perspective including psychology and sociology—is now one of the most vital research programs, and it stands in sharp contradiction to much of efficient markets theory” (p. 83). The emergence of this theory is the result of the insufficiency of a rational approach to predicting market behaviors in real-life conditions. Markiel (2003) explains Shiller’s approach in the following manner: while the stock markets exist, investors’ aggregate judgment will make mistakes from time to time. Moreover, some market players are irrational. As a result, price anomalies and even predictable patterns in stock returns can emerge over time and even survive for short periods. Moreover, the market cannot be entirely efficient since there would be no motivation for specialists to discover the knowledge reflected in market pricing. In the modern world, with the growing popularity of BigData and other data analysis tools, it would be easy to determine these anomalies and use the information to make accurate predictions.
One issue with the use of data is that it is unlikely that stock market professionals can efficiently collect and use such information in real life. Periods where “bubbles” appear to have arisen, at least in particular areas of the market, are thankfully the exception rather than the rule (Malkiel, 2003). Furthermore, any patterns or irrationalities in the price of particular companies that have been uncovered in the quest for historical experience are unlikely to endure and will not present investors with a way to achieve remarkable profits.
Although anomalies within the stock market are recognized phenomena, not much attention has been given to them under traditional theoretical approaches. Shiller (2003) provides the following conclusion to his approach: the partnership between finance and other social sciences, known as behavioral finance, has resulted in a dramatic strengthening of our understanding of financial markets. This approach, however, does not guarantee that one can make accurate predictions about the financial markets. Efficient markets theory may result in dramatically inaccurate interpretations of events such as massive stock market bubbles (Shiller, 2003). Therefore, it is dangerous to undermine the psychological and social factors that might be affecting the financial markets.
In summary, this paper analyzes the publications of Robert Shiller, where the author addresses the Efficient Markets Theory. The main argument of the author is that the US market is highly volatile, which undermines the main arguments of the Efficient Market Theory. Moreover, in recent years, the theory of Behavioral Finance has been growing in popularity since it addresses some of the factors that explain the financial decisions of people based on the understanding of human psychology, as opposed to mere calculations.
References
Barrett, D. (n.d.). Stock market volatility – A psychological phenomenon? Web.
Malkiel, B. (2003). The Efficient Market hypothesis and its critics. Journal of Economic Perspectives, 17(1), 59-82.
Shiller, R. J. (2003). From Efficient Markets Theory to Behavioral Finance. Journal of Economic Perspectives, 17(1), 83-104.