The Efficient Market Hypothesis (EMH) is considered the cornerstone of modern financial theory. However, this hypothesis does not account for irrationality because it assumes that the market price of a security reflects the impact of all relevant information as it is released. This essay aims at examining Behavioral Finance, a school of thought which posts behavioral challenge to the market efficiency.
In the essay, several behavior biases in the attached article would be discussed first, followed by a further evaluation of the investment style differences between genders. Finally, the impact of these behavior problems on the market efficiency would be evaluated as well.
1. Behavioral Biases
In real life, people do not usually act like rational men as perceived by many economists. In particular, two behavior biases are discussed in the attached article.
Over-Optimism
One indication for over-optimism is that people tend to exaggerate their capabilities. For example, a study found a large majority of children in Lake Woebegone believe that they are good drivers, which is, of course, objectively impossible. The same holds for student’s evaluation of their own work performance. A significant portion of students (80%) think they will perform in the top 50% of the class. The outcome is that at least 30% of these students cannot live up to their own expectations at the end of the course. Hence, overly optimistic people tend to display unrealistically rosy assessment of their abilities and prospects.
The consistent over-optimism may in part stem from two psychological biases, self-attribution and illusion of control. Self attribution refers to people’s tendency to ascribe any success they have in some activity to their own talents, while blaming failure on bad luck over which they have no control. The illusion of control is the tendency for people to overestimate their ability to control events, for instance to feel that they control outcomes that they... [continues]
In the essay, several behavior biases in the attached article would be discussed first, followed by a further evaluation of the investment style differences between genders. Finally, the impact of these behavior problems on the market efficiency would be evaluated as well.
1. Behavioral Biases
In real life, people do not usually act like rational men as perceived by many economists. In particular, two behavior biases are discussed in the attached article.
Over-Optimism
One indication for over-optimism is that people tend to exaggerate their capabilities. For example, a study found a large majority of children in Lake Woebegone believe that they are good drivers, which is, of course, objectively impossible. The same holds for student’s evaluation of their own work performance. A significant portion of students (80%) think they will perform in the top 50% of the class. The outcome is that at least 30% of these students cannot live up to their own expectations at the end of the course. Hence, overly optimistic people tend to display unrealistically rosy assessment of their abilities and prospects.
The consistent over-optimism may in part stem from two psychological biases, self-attribution and illusion of control. Self attribution refers to people’s tendency to ascribe any success they have in some activity to their own talents, while blaming failure on bad luck over which they have no control. The illusion of control is the tendency for people to overestimate their ability to control events, for instance to feel that they control outcomes that they... [continues]
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