Efficient Market Hypothesis and Behavioral Finance

Topics: Financial markets, Risk aversion, Prospect theory Pages: 17 (5921 words) Published: February 19, 2012
Efficient market hypothesis and Behavioral finance

Fall 2011 Teacher: Guðrún Johnsen V-780-BFIM

Student: Rúnar Guðnason SSN:1804784939

Table of Contents
Introduction ................................................................................................................................ 3 1.1 Efficient market hypothesis .................................................................................................. 3 1.2 A criticism on the efficient market hypothesis ................................................................. 4 2.1 Behavioral finance and the efficient market hypothesis ...................................................... 5 2.2 Prospect theory and Loss aversion ................................................................................... 6 2.3 Mental accounting ............................................................................................................ 8 2.4 Framing ............................................................................................................................. 9 2.5 Overconfidence ............................................................................................................... 10 2.6 Representativeness heuristic ........................................................................................... 11 2.7 Conservatism .................................................................................................................. 12 2.8 Feedback theory (herd behavior) .................................................................................... 12 2.9 Limits to arbitrage .......................................................................................................... 13 3.1 The defense for the efficient market hypothesis ................................................................ 14 4.1 Discussion .......................................................................................................................... 15 References ................................................................................................................................ 17

1

Abstract
In this paper some interesting findings about market efficiency are deliberated, from Fama´s random walk theory to recent theories of behavioral finance. Behavioral finance uses models in which some agents are not fully rational. Traditional finance theories, like the efficient market theory and the expected utility theory, seeks to understand financial markets using models in which agents are rational. Scholars that have dedicated their live work in researching market efficiency do not agree. The advocates of the traditional finance theories believe that markets are efficient because markets are rational, at least in the long run, while the advocates of behavioral finance believe that markets are inefficient because of people´s irrationality.

2

Introduction
The efficient market hypothesis assumes that security prices equal their fundamental value and that investors are rational. The theory was widely considered to be proved before the 1990s, when researches in the field of Behavioral finance and researches on anomalies in the stock market became popular topic. Controversially behavioral finance argues that markets are not efficient because asset prices deviates from fundamental values, caused by behavior of traders who are not fully rational (Barberis and Thaler, 2003). Surveys of the efficient markets literature and the debate of market efficiency date back at least to Fama (1970). The scholars that have dedicated their lifework to research market efficiency do not agree. They are mainly divided into two blocks, the efficient market hypothesis advocates and the behavioral finance advocates. The goal of writing this paper is to highlight some interesting findings that have emerged from researches on market efficiency and to see if those findings can bring us any closer to answering the question, whether...
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