Question

Are the markets efficient? If the markets were completely efficient, how would you explain the dot-com bubble of the late 1990s and the subsequent bear market? Compare and contrast this episode with the current housing market.

Answer 1

Efficient market is one where the market price is an unbiased estimate of the true value of the investment. It means that prices can be greater or less than true value but these deviations are random in nature. But in real world there are deviations from the efficient markets hypothesis as people are not always rational. The dot-com bubble of the late 1990s has burst due to speculative market practices in many software start-up companies and the subsequent bear market after the bubble burst.

These situations can be explained by behavioral finance where in real world there are deviations from the efficient markets hypothesis because of investor’s psychology; sometime investors are bias in their approach therefore sometime it is difficult for investors to take advantage of mispriced securities. Sometime they get trapped in to some misinformation and not able to analyze the situation. The behavior of investors is different in different market conditions and sometime they overestimate their abilities to predict or time the market.

While comparing this episode with the housing market, there is a lot of similarities in the pattern; a housing bubble is related to the real estate market where the increase in the prices is very rapid but it is not able to sustain itself therefore it get burst after reaching higher level. It has followed the financial crisis of 2007-08 in the country and U.S. subprime mortgage crisis. It is resulted in the shortage of required assets in the economy and also the collapse of the financial sectors. In my opinion it is more related to investor’s sentiment and can be better explained by Behavioral finance which is based on human psychology.