Investor Irrationality and Self Defeating Behavior
A Critical Analysis of: Investor Irrationality and Self-Defeating Behavior
Introduction For many years, finance traditionalists have held on to the theory that markets are efficient and that prices correctly reflect the information available to the market as a whole. This has come to be known as the efficient market hypothesis which was originally postulated by Eugene Fama in 1965. After a thorough statistical study of the movements of investment prices Fama concluded that “such movements were essentially random and unpredictable” (Shefrin p.75). Fama pointed out that “in an efficient market, prices correspond to intrinsic (or fundamental) value” (Shefrin p.75). In short, what the theory concludes is that it is impossible to beat the market; that no investor can ever purchase undervalued stocks or sell stocks at inflated prices. The market will always correct itself by incorporating all relevant information into the price of a security thus eliminating an individual investor’s ability to outperform. EMH has grown to become a cornerstone of financial theory and is still applied by many traditionalists when attempting to explain the behavior of financial markets.
While there is much evidence in support of this theory there is an equal amount dissention. There are many who argue that there is ample evidence available that counters the central ideas of EMH and demonstrate its shortcomings such as: individuals who have shown that they can consistently beat the market as in the case of Warren Buffet; or the recent bursting of the dot com and real estate bubbles, two events which clearly show that market prices can seriously deviate from their fair values. Given the mounting evidence in direct contrast to EMH “new attempts are being made to explain the behavior of financial markets, one of the foremost of which is in the area of behavioral finance” (Singh p.116).
In his article Investor Irrationality and Self Defeating Behavior:
Introduction For many years, finance traditionalists have held on to the theory that markets are efficient and that prices correctly reflect the information available to the market as a whole. This has come to be known as the efficient market hypothesis which was originally postulated by Eugene Fama in 1965. After a thorough statistical study of the movements of investment prices Fama concluded that “such movements were essentially random and unpredictable” (Shefrin p.75). Fama pointed out that “in an efficient market, prices correspond to intrinsic (or fundamental) value” (Shefrin p.75). In short, what the theory concludes is that it is impossible to beat the market; that no investor can ever purchase undervalued stocks or sell stocks at inflated prices. The market will always correct itself by incorporating all relevant information into the price of a security thus eliminating an individual investor’s ability to outperform. EMH has grown to become a cornerstone of financial theory and is still applied by many traditionalists when attempting to explain the behavior of financial markets.
While there is much evidence in support of this theory there is an equal amount dissention. There are many who argue that there is ample evidence available that counters the central ideas of EMH and demonstrate its shortcomings such as: individuals who have shown that they can consistently beat the market as in the case of Warren Buffet; or the recent bursting of the dot com and real estate bubbles, two events which clearly show that market prices can seriously deviate from their fair values. Given the mounting evidence in direct contrast to EMH “new attempts are being made to explain the behavior of financial markets, one of the foremost of which is in the area of behavioral finance” (Singh p.116).
In his article Investor Irrationality and Self Defeating Behavior:
References: Ackert, L.F., Deaves, R. (2010). Behavioral Finance. South-Western Cengage Learning Singh, S. (2012). Investor irrationality and self-defeating behavior: Insights from behavioral finance. Journal of Global Business Management, 8(1), 116-122. Retrieved from http://ezproxy.umuc.edu/login?url=http://search.proquest.com/docview/993153659?accountid=14580 Shefrin, Hersh M., (2007). Behavioral Corporate Finance McGraw-Hill Irwin