Efficient Market Hypothesis and Behavioral Finance Essay

5928 Words Feb 26th, 2012 24 Pages
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 ................................................................. 4 2.1 Behavioral finance and the efficient market hypothesis ...................................................... 5 2.2 Prospect theory and Loss aversion
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Chapter 2 will be dedicated to behavioral finance and the findings of its literature on market efficiency. In chapter 3 the criticism by the market efficiency advocates on the work of the behavioral finance advocates will be deliberated. Chapter 4 contains brief discussion about market efficiency.

1.1 Efficient market hypothesis
Before the 1960s many investors believed that stock prices tended to repeat itself and many investors used the behavior of past prices to predict about future prices (Fama, 1965). In the paper Random walks in stock market prices that were published in 1965, Eugene Fama came to that conclusion that stock prices follow a random walk. The random walk theory states that investors cannot use past prices to predict future prices, because the stock price today is the stock price yesterday plus a random increase or decrease in the stock price, which is independent of yesterday´s stock price. In 1970 Fama set forth the efficient market hypothesis which argues that prices on the market reflects all known information at any given time and new information on the market will influence the market immediately.
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In this same article Fama also indentified three form of market efficiency. The weak form claims that prices on securities follow a random walk, meaning that past prices cannot be predicted by future prices because prices today, reflect all information known to the public about past prices. The semi-strong form claims that

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