Efficient Market Hypothesis and Behavioral Finance – Is a Compromise in Sight?

Better Essays
Efficient Market Hypothesis And Behavioral Finance – Is A Compromise In Sight?
By Nikolai Chuvakhin

Legend has it that once upon the time two economists were walking together when one of them saw something that struck his mind. “Look,” he exclaimed, “here’s a great research topic!” “Nonsense,” the other one said, “If it were, someone would have written a paper on it by now.” For a long time this attitude governed the view of economists toward the stock market. Economists simply believed that the stock market was not a proper subject for serious study. Indeed, most of the pre-1960 research on security prices was actually done by statisticians. The Pre-History: Statistical Research Most of the early statistical research of the stock market concentrated around the same question: are security prices serially correlated? Do security prices follow a random walk? Are prices on any given day as likely to go up as they are to go down? A number of studies concluded that successive daily changes in stock prices are mostly independent. There seemed to be no pattern that could predict the future direction of price movements. One of the most interesting (and currently relevant) research projects of that earlier era was undertaken by Harry Roberts, a statistician at the University of Chicago. In his paper, “Stock Market ‘Patterns’ and Financial Analysis,” published in the Journal of Finance in 1959, Roberts wrote: If the stock market behaved like a mechanically imperfect roulette wheel, people would notice the imperfections and, by acting on them, remove them. This rationale is appealing, if for no other reason than its value as counterweight to the popular view of stock market “irrationality,” but it is obviously incomplete. Roberts generated a series of random numbers and plotted the results to see whether any patterns that were known to technical analysts would be visible. Figure 1 provides an example of Roberts’ plot:

Efficient Market Hypothesis And Behavioral



References: Barber, Brad, and Terrance Odean (2000), “Too Many Cooks Spoil the Profits: Investment Club Performance,” Financial Analysts Journal, vol. 56, no. 1 (January/February), 17-25. Benninga, Simon (2000), Financial Modeling (Cambridge, Massachusetts: MIT Press) Chen, Joseph, and Harrison Hong (1999), “Differences of Opinion, Rational Arbitrage and Market Crashes,” NBER Working Paper No. 7376 (Cambridge, Massachusetts: National Bureau of Economic Research). Chen, Joseph, Harrison Hong, and Jeremy Stein (2000), “Forecasting Crashes: Trading Volume, Past Returns and Conditional Skewness in Stock Prices,” NBER Working Paper No. 7687 (Cambridge, Massachusetts: National Bureau of Economic Research). De Bondt, Werner, and Richard Thaler (1985), “Does the Stock Market Overreact?” Journal of Finance, vol. 40, no. 3 (July), 793-808. Fama, Eugene (1965), “Random Walks in Stock Market Prices,” Financial Analysts Journal, vol. 21, no. 5 (September/October), 55-59. Fama, Eugene (1965), “The Behavior of Stock Market Prices,” The Journal of Business, vol. 38 (January), 34-105. Fama, Eugene, Lawrence Fisher, Michael Jensen, and Richard Roll (1969), “The Adjustment of Stock Prices to New Information,” International Economic Review, vol. 10, 1-21. 16 Efficient Market Hypothesis And Behavioral Finance—Is A Compromise In Sight? Finn, Mark, Russell Fuller, and John Kling (1999), “Equity Mispricing: It’s Mostly on the Short Side,” Financial Analysts Journal, vol. 55, no. 6 (November/December), 117-126. Gibbons M., and P. Hess, (1981) “Day of the Week Effects and Assets Returns,” Journal of Business, vol. 54, 579-596. Grossman, Sanford, and Joseph Stiglitz (1980), “On the Impossibility of Informationally Efficient Markets,” American Economic Review 70, 393-408. Harrington, Brooke (1998), “The Social Construction of Investing: A Case Study of Identity Formation in Investment Clubs.” Working paper. Harvard University (August). Jensen, Michael (1978), “Some Anomalous Evidence Regarding Market Efficiency,” Journal of Financial Economics, vol. 6, nos. 2/3, 95-101. Johnson, W. Bruce, Robert P. Magee, Nandu J. Nagarajan, and Harry A. Newman (1985), “An Analysis of the Stock Price Reaction to Sudden Executive Deaths,” Journal of Accounting and Economics, 1985, 151-174. Keim, Donald (1989), “Trading Patterns, Bid-Ask Spreads, and Estimated Security Returns: The Case of Common Stock Returns at the Turn of the Year,” Journal of Financial Economics, vol. 25, no.1, 75-98. Lintner, John (1956), “Distribution of Incomes of Corporations among Dividends, Retained Earnings, and Taxes,” American Economic Review, vol. 46, no. 2 (May), 97-113. Oppenheimer, Henry R. (1981), Common Stock Selection: an Analysis of Benjamin Graham’s “Intelligent Investor” Approach (Ann Arbor, Michigan: UMI Research Press). Rendelman, Richard J., Charles P. Jones, and Henry A. Latané (1982), “Empirical Anomalies Based on Unexpected Earnings and the Importance of the Risk Adjustments,” Journal of Financial Economics, vol. 10, no. 3, 269-287. Roberts, Harry (1959), “Stock Market ‘Patterns’ and Financial Analysis: Methodological Suggestions,” Journal of Finance, Vol. XIV, No. 1, 1-10. Rozeff, M. and W. Kinney (1976), “Capital Market Seasonality: The Case of Stock Returns,” Journal of Financial Economics 3, 379-402. Shiller, Robert (1981), “Do Stock Prices Move Too Much to Be Justified by Subsequent Changes in Dividends?” American Economic Review , vol. 71, no. 3 (June), 421436. Simon, Herbert (1947), Administrative Behavior (New York: Macmillan Co.) 17 Efficient Market Hypothesis And Behavioral Finance—Is A Compromise In Sight? Spence, Michael (1973), “Job Market Signaling,” Quarterly Journal of Economics 87, 355-374. Statman, Meir (1999), “Behavioral Finance: Past Battles, Future Engagements,” Financial Analysts Journal, vol. 55, no. 6 (November/December), 18-27. Thaler, Richard (1999), “The End of Behavioral Finance,” Financial Analysts Journal, vol. 55, no. 6 (November/December), 12-17. 18

You May Also Find These Documents Helpful

  • Powerful Essays

    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…

    • 1347 Words
    • 6 Pages
    Powerful Essays
  • Powerful Essays

    Efficient market hypothesis and Behavioral finance Fall 2011 Teacher: Guðrún Johnsen V-780-BFIM Student: Rúnar Guðnason SSN:1804784939 Table of Contents Introduction ................................................................................................................................ 3 1.1 Efficient market hypothesis .................................................................................................. 3 1.2 A criticism on the efficient market hypothesis ........…

    • 5921 Words
    • 24 Pages
    Powerful Essays
  • Powerful Essays

    Efficient Market Hypothesis When establishing financial prices, the market is usually deemed to be well-versed and clever. In a stock market, stocks are based on the information given and should be priced at the accurate level. In the past, this was supposed to be guaranteed by the accessibility of sufficient information from investors. However, as new information is given the prices would shift. “Free markets, so the hypothesis goes, could only be inefficient if investors ignored price sensitive…

    • 1629 Words
    • 7 Pages
    Powerful Essays
  • Good Essays

    The efficient-market hypothesis emphasizes that arbitrage will rapidly eliminate any profit opportunities and drive market prices back to fair value. Behavioral-finance specialists may concede that there are no easy profits, but argue that arbitrage is costly and sometimes slow-working, so that deviations from fair value may persist. Sorting out the puzzles will take time, but we suggest that financial managers should assume, at least as a starting point, that there are no free lunches to be…

    • 515 Words
    • 3 Pages
    Good Essays
  • Good Essays

    What is your opinion of the Efficient Market Hypothesis? When it comes to the valuation of a particular stock do you think that all information regarding the company is in the public domain? What brought you to your opinions? The Efficient Markets Hypothesis (EMH) according to Brigham and Ehrhardt (2011) “asserts that (1) stocks are always in equilibrium and (2) it is impossible for an investor to “beat the market” and consistently earn a higher rate of return than is justified by the…

    • 871 Words
    • 4 Pages
    Good Essays
  • Satisfactory Essays

    Chapter 13 Efficient Market Hypothesis Road Map Part A Introduction to Finance. Part B Valuation of assets, given discount rates. Part C Determination of discount rates. Part D Introduction to corporate finance. • Efficient Market Hypothesis (EMH). • Capital investment decisions (capital budgeting). • Financing decisions. Main Issues • Efficient Market Hypothesis (EMH) • Empirical evidence on EMH • Implications of EMH • Questions and practical issues about EMH 13-2 Efficient Market Hypothesis…

    • 1509 Words
    • 7 Pages
    Satisfactory Essays
  • Better Essays

    Efficient Market Hypothesis

    • 20400 Words
    • 82 Pages

    American Finance Association Efficient Capital Markets: II Author(s): Eugene F. Fama Source: The Journal of Finance, Vol. 46, No. 5 (Dec., 1991), pp. 1575-1617 Published by: Blackwell Publishing for the American Finance Association Stable URL: http://www.jstor.org/stable/2328565 Accessed: 30/03/2010 21:19 Your use of the JSTOR archive indicates your acceptance of JSTOR 's Terms and Conditions of Use, available at http://www.jstor.org/page/info/about/policies/terms.jsp. JSTOR 's Terms and…

    • 20400 Words
    • 82 Pages
    Better Essays
  • Powerful Essays

    Objectives Capital market, being an essential element of today’s economy, demands an intensive and special attention. The objective of this study is to look into every aspect of Bangla-desh capital market and identify its various pros and cons along with efficient market hypothesis. The specific objectives of this study are: To give an overall idea about the capital market-its structures, functions, importance, etc. To compare the relative conditions of Bangladesh capital market effeciency.…

    • 2123 Words
    • 9 Pages
    Powerful Essays
  • Powerful Essays

    Efficient Market Hypothesis

    • 2992 Words
    • 12 Pages

    several decades the efficiency of stock market has been the sole purpose of research studies. As a result, several theories have been introduced and implemented in relation to principally how the competition in the stock market will force the known information into the prices of securities. The knowledge of information on a variety of securities that are traded in the market is one of the major factors in influencing the movements of stock market. In the stock market, a securities price tends to move rise…

    • 2992 Words
    • 12 Pages
    Powerful Essays
  • Good Essays

    The Efficient Markets Hypothesis The theory of Efficient Markets Hypothesis (EMH) asserts that (1) stocks are always in equilibrium and (2) it is impossible for an investor to “beat the market” and consistently earn a higher rate of return than is justified by the stock’s risk. Those who believe in the EMH note that there are 100,000 or so fulltime, highly trained, professional analysts and traders operating in the market, while there are fewer than 3,000 major stocks. Therefore, if each analyst…

    • 486 Words
    • 2 Pages
    Good Essays