From the Efficient Market Hypothesis to Behavioral Finance: How Investors' Psychology Changes the Vision of Financial Markets

From the Efficient Market Hypothesis to Behavioral Finance
How Investors’ Psychology Changes the Vision of Financial Markets by ADAM SZYSZKA

Poznan University of Economics Poland [e-mail]

I. Introduction

The efficient market hypothesis (EMH) has been the key proposition of traditional (neoclassical) finance for almost forty years. In his classic paper, Fama (1970) defined an efficient market as one in which “security prices always fully reflect the available information” [p.383]. In other words, if the EMH holds, the market always truly knows best. Until the mid-1980s the EMH turned into an enormous theoretical and empirical success. Academics from most prestigious universities and business schools developed powerful theoretical reasons why the efficient paradigm should hold. This was accompanied by a vast array of early empirical research – nearly all of them supporting the EMH. The idea that the market knows best was promoted in business press and taught at various MBA and other courses. It strongly influenced the investment community (increased popularity of index funds and the buy-and-hold strategy), but luckily not everybody. From the beginning of the 1980s, and more and more in the 1990s, new empirical studies of security prices have reversed some of the earlier evidence favoring the EMH. The traditional finance school named these observations anomalies, because they could not be explained in the neoclassical framework. In the response to a growing number of puzzles, a new approach to financial markets has emerged – behavioral finance. It focuses on investors’ behavior and the decision making process. In the contrary to the classical paradigm, behavioral finance assumes that agents may be irrational in their reactions to new information and make wrong in investment decisions. As a result, markets will not always be efficient and asset pricing may deviate from predictions of traditional market models.

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