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

Topics: Financial markets, Capital asset pricing model, Financial economics Pages: 16 (5737 words) Published: May 8, 2013
From the Efficient Market Hypothesis to Behavioral Finance
How Investors’ Psychology Changes the Vision of Financial Markets by


Poznan University of Economics Poland

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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This paper confronts the main foundations of the neoclassical theory of the capital market and asset pricing with allegations of behavioral finance. Cornerstones of the traditional theory are discussed in the first section. It is followed by a brief presentation of the behavioral approach. Further, the paper discusses consequences of the new view of finance to capital market practitioners – investors, corporate finance, and policy makers. The paper concludes with final remarks and some thoughts on the future development of the capital market theory.

II. The Traditional view

The EMH rests on three assumptions. Each of them is progressively weaker. First, investors are assumed to be rational and hence to value assets rationally. They should value each security for its fundamental value: the net present value of future cash flows, discounted by a rate appropriate to the risk level. When investors learn something new about future cash flows or risk attached to a particular security, they should quickly and appropriately (no under- and no over-reaction) respond to the new information by bidding up prices when the news is good or bringing them down when the news is bad. As a consequence, asset prices should incorporate all the available information almost immediately. If one would like to consistently make more money than the average on the market based only on publicly available information, one would have to react always quicker to new than the rest of market participants, and this is obviously not possible every time. However, markets may remain efficient even if not all investors are rational and some of them make mistakes in perceiving and reacting to information. In such a case, it is assumed that irrational investors in the market trade randomly. When their trading decisions are uncorrelated, their impact is likely to cancel each other out. Altogether they will not generate a market force that could influence the...

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