The Fama critique compared to new research
Over the last couple of decades there has been a debate going whether or not there are behavioral aspects in finance. This means that financial markets are subject to different investors’ sentiments and that markets are not efficient, i.e. the efficient market hypothesis (EMH) does not hold. The supporters of EMH argue that all available information is included in the stock prices, which means that any long-term abnormal returns earned are a matter of chance. On the other side, the supporters of behavioral finance argues that because of over- and under-reaction by investors to information, it takes time before prices fully adjust and thus there is an opportunity to earn long-term abnormal returns.
In 1998 Eugene F. Fama published a famous critique on long-term return anomalies. He infers that all anomalies that was pointed out in scientific papers up until then where a matter of chance. His argues that it is easy to show the weaknesses of behavioral models and proof of anomalies. If there is a more or less even split between over- and under-reaction, and continuation and reversal of returns, then this supports the market efficiency hypothesis that any abnormal returns are chance. He also infers that with a reasonable change in methodology used, the anomalies are severely reduced or disappears completely.
In the years after his critique was published there have been a lot of papers contradicting Fama’s view and giving support to the behavioral aspect of finance, saying that EMH is not valid for financial markets due to over- and under-reaction by investors due to overconfidence. In this essay I am going to look closer at two papers which focus on how investors’ different reactions to information increases trading volume on the market (Odean, 1998) and which stocks are traded (Barber and Odean, 2007) . These both find evidence that the over-reaction of investors to certain information influence their trading and thus the market. This contradicts the theory of an efficient market where all reactions in the market are rational.
I will first present some brief theory on the Efficient Market Hypothesis and behavioral finance. Then I give an overview of the critique by Fama (1998). In the next section I will present the main points of the articles by Odean (1998), and Barber and Odean (2007). These are then compared to the relevant conclusions of Fama.
Efficient market hypothesis (EMH)
The EMH states that all the available information in the market is immediately absorbed in the stock prices and that all investors are rational and therefore only acts in the face of new information. Any movement away from the rational expected return on a portfolio is a product of chance and cannot be specified: The expected value of abnormal returns is zero, but chance generates apparent anomalies that split randomly between over-reaction and under-reaction.
In the field of behavioral finance investors are believed to over- or under-react to information presented to them, which leads them to make irrational decisions, contradicting the theory of efficient markets. If this is the case, then markets are no longer efficient and it is possible to systematically earn abnormal returns since anomalies exist on the market. Investors over- and under-react due to being overconfident in their own information. Psychologists find that people overweight salient information (stands out and captures attention), and give too much consideration to how extreme information is and not enough to its validity. They overweight information that is consistent with their existing beliefs, are prone to gather information that supports these beliefs and readily dismiss information that does not.
3. Fama’s critique
In the paper of Fama (1998) he argues there is not enough evidence to disregard the EMH for a number of reasons. First, literature does...
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