Empirical Challenges of the Efficient Market Hypothesis Essay

2067 Words Oct 31st, 2012 9 Pages
Empirical Challenges to the Efficient Market Hypothesis

1. Introduction

Random walks observed in stock return series prior to the 1970s puzzled a number of financial theorists and practitioners. In 1970, this puzzle was resolved by Eugene Fama (1970) who argued that the random walks observed in the behaviour of stock return series could be attributed to market efficiency. Market efficient meant that investors could not consistently make risk-adjusted returns by making investment decisions that were based solely on past stock market information. This is because; the information was already reflected in the stock price. Following its initial proposition, the efficient market hypothesis has remained one of the most important topics
…show more content…
According to behavioural finance theory, investor behaviour is influenced by psychological factors, which means that stock market anomalies can be attributed to psychological-based theories. The investment decisions of individuals and the behaviour of stock prices are systematically influenced by the structure of market information as well as the characteristics of investors (Bodie et al., 2007).

Behavioural finance theorists argue against the efficient market hypothesis on the grounds that the assumptions underlying the EMH are unrealistic. The traditional EMH framework assumes that investors are rational. However, Barberies and Thaler (2003) argue that this assumption is “too simple and very appealing”. While some investors may be rational in their thinking, it is difficult to conceptualise the behaviour of investors based solely on rationality. Some of the actions of investors are irrational and as such basing the EMH on a rational framework can lead to misleading conclusions about the efficiency of markets (Barberies et al., 1998; Hong and Stern, 1999; Baberies and Thaler, 2003). Investors do not react to information in the manner in which the efficient market hypothesis suggests. Investors tend to initially overreact or underreact to information when it is first made available to the

Related Documents