Efficient Market Hypothesis V's Behavioural Finance

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Efficient Market Hypothesis v’s Behavioural Finance

An efficient market is one in which share prices quickly and fully reflect all available information, where investors are rational, and there are no frictions. Investors determine stock prices on the basis of expected cash flows to be received from a stock and the risk involved. Rational investors should use all the information they have available or can reasonably obtain, including both known information and beliefs about the future. In an efficient market there is “no free lunch”: no investment strategy can earn excess risk-adjusted average returns, or average returns greater than are warranted for its risk (Barberis, 2003). Market efficiency is assessed by determining how well information is reflected in stock prices. In a perfectly efficient market, security prices quickly reflect all available information and investors are not able to use available information to earn excess returns as it is already incorporated in prices. The hypothesis that says security prices reflect all available information thus making it difficult for investors to make abnormal returns is the efficient market hypothesis (EMH). The foundations of EMH rest on three basic arguments 1) investors are assumed to be rational and hence they value securities rationally, 2) to the extent that some investors are not rational, their trades are random and hence cancel each other out ultimately having no effect on prices, and 3) if investors are irrational, they will be met in the market by rational arbitragers who will eliminate any influence they have on the market (Lawrence, McCabe & Prakash, 2007). However many members of the academic community disagree and argue that none of the three conditions of market efficiency is likely to hold in reality and as a result what is called Behavioural Finance has emerged. Behavioural finance states that the market is not efficient and adherents argue that investor are not rational, deviations from rationality are similar across investors, and, arbitrage, being costly, will not eliminate inefficiencies. Barberis (2003, p.1054) argues that some features of asset prices are most plausibly interpreted as deviations from fundamental value, and that these deviations are brought about by the presence of traders who are not fully rational. Behavioural Finance highlights inefficiencies such as under or over reactions to information as causes of market trends, and in some cases bubbles and crashes. These reactions have been attributed to limited investor attention, over/under confidence/optimism, herding instinct and noise trading. Behaviourists point to many studies, including those showing that there are limits to arbitrage, that small company shares outperform large company shares, value stocks outperform growth stocks, and share prices adjust slowly to earnings surprises as empirical confirmation of their beliefs. Market anomalies are techniques or strategies that appear to be contrary to an efficient market i.e. they highlight flaws and inefficiencies, and constitute exceptions to market efficiency. The development of behavioural finance offers a clearly defined alternative hypothesis to EMH and provides a foundation for putting these studies of contradictions, or anomalies, in perspective (Jones, 2005 p335). Limits to arbitrage argue that it can be difficult for rational trades to undo the dislocations caused by less rational traders (Barberis, 2003). Friedman (1953) argues this and says that “rational traders will quickly undo any dislocations caused by irrational traders”. However Friedman’s argument hasn’t withstood theoretical scrutiny. The argument is based on two assentation’s; firstly as soon as there is a deviation from fundamental value or a mispricing an attractive investment opportunity is created, and secondly this opportunity will immediately be snapped up by rational traders, thus correcting the mispricing (Barberis, 2003). It is the first step...
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