Efficient Market Hypothesis and Behavioral Finance

Topics: Financial markets, Behavioral finance, Economics Pages: 4 (1347 words) Published: March 15, 2013
Efficient market hypothesis (EMH), first promulgated by Eugene F. Fama (1970), suggests that financial markets price assets precisely at their intrinsic worth given all publicly available information. Though several empirical works strongly confirm market efficiency, some of the hypotheses do not agree with the efficient market hypothesis, such as behavior finance hypothesis. This essay will discuss the assumption of efficient market hypothesis and implications when these assumptions do not hold. This essay also discusses the differences between neoclassical finance and behavior finance. Efficient market hypothesis states that if one or more of the following assumption holds, the market will be efficient. It first assumes that investors act rationality. It means that everyone in the stock market will adjust their expectation on the stock price in a rational way after new information announced. EMH also assumes that some investors are independently deviate from rationality meaning they are over optimistic and some of them are over pessimistic over the stock price. As their actions are random, these will neutralize the effect on stock price caused by any irrational investment decision. The last assumption is that investors will scramble for any arbitrage chance which means “buy low sell high”. When a piece of information is announced, all investors will adjust the expected stock price at the same level and immediately buy the “underpriced” stock or sell the “overpriced stock” to maximize their earnings. Although there are some irrational investors, the arbitrage mechanism helps driving out any mispricing caused by any irrational actions. However, in my opinion, these assumptions are not realistic and may not always hold in the real world. Some research shows that these assumptions are not correct and are not always hold in the real world. According to F. Black (1986), some investors may not act as rational as EMH assumes. They may buy a particular stock only...
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