Inefficient Markets: An Introduction to Behavioral Finance

Inefficient Markets: An Introduction to Behavioral Finance

Inefficient Markets: An Introduction to Behavioral Finance

Inefficient Markets: An Introduction to Behavioral Finance

Synopsis

The efficient markets hypothesis has been the central proposition in finance for nearly thirty years. It states that securities prices in financial markets must equal fundamental values, either because all investors are rational or because arbitrage eliminates pricing anomalies. This book describes an alternative approach to the study of financial markets: behavioral finance. This approach starts with an observation that the assumptions of investor rationality and perfect arbitrage are overwhelmingly contradicted by both psychological and institutional evidence. In actualfinancial markets, less than fully rational investors trade against arbitrageurs whose resources are limited by risk aversion, short horizons, and agency problems. The book presents and empirically evaluates models of such inefficient markets. Behavioral finance models both explain the available financial data better than does the efficient markets hypothesis and generate new empirical predictions. These models can account for such anomalies as the superior performance of value stocks, the closed end fund puzzle, the high returns onstocks included in market indices, the persistence of stock price bubbles, and even the collapse of several well-known hedge funds in 1998. By summarizing and expanding the research in behavioral finance, the book builds a new theoretical and empirical foundation for the economic analysis ofreal-world markets.

Excerpt

The efficient markets hypothesis (EMH) has been the central proposition of finance for nearly thirty years. In his classic statement of this hypothesis, Fama (1970) defined an efficient financial market as one in which security prices always fully reflect the available information. The efficient markets hypothesis then states that real-world financial markets, such as the U.S. bond or stock market, are actually efficient according to this definition. The power of this statement is dazzling. Perhaps most radically, the EMH 'rules out the possibility of trading systems based only on currently available information that have expected profits or returns in excess of equilibrium expected profit or return' (Fama 1970). In plain English, an average investor—whether an individual, a pension fund, or a mutual fund—cannot hope to consistently beat the market, and the vast resources that such investors dedicate to analyzing, picking, and trading securities are wasted. Better to passively hold the market portfolio, and to forget active money management altogether. If the EMH holds, the market truly knows best.

In the first decade after its conception in the 1960s, the EMH turned into an enormous theoretical and empirical success. Academics developed powerful theoretical reasons why the hypothesis should hold. More impressively, a vast array of empirical findings quickly emerged—nearly all of them supporting the hypothesis. Indeed, the field of academic finance in general, and security analysis in particular, was created on the basis of the EMH and its applications. The University of Chicago, where the EMH was invented, justly became the world's center of academic finance. In 1978, Michael Jensen—a Chicago graduate and one of the creators of the EMH—declared that 'there is no other proposition in economics which has more solid empirical evidence supporting it than the Efficient Markets Hypothesis' (Jensen 1978 , p. 95).

Such strong statements portend reversals, and the EMH is no exception. In the last twenty years, both the theoretical foundations

Search by... Author
Show... All Results Primary Sources Peer-reviewed

Oops!

An unknown error has occurred. Please click the button below to reload the page. If the problem persists, please try again in a little while.