An Insight into Behavioral Finance Models, Efficient Market Hypothesis and Its Anomalies

By Jain, Vaibhav | Researchers World, July 2012 | Go to article overview

An Insight into Behavioral Finance Models, Efficient Market Hypothesis and Its Anomalies


Jain, Vaibhav, Researchers World


ABSTRACT

This research attempts to explain the literature on Efficient Market Hypothesis, its anomalies and also a brief discussion on different trading Strategies. In this part, we will discuss various Behavioral Finance Models like Over and Under-reaction, Mental Compartments, Over Confidence, Disjunction Effect, Limits to Arbitrage in addition to the theories of human behavior like Prospect and Expected Utility Theories.

In the initial part of this research, we have explained how security prices incorporate all information immediately without giving the chance to the investors to profit from them. We have also discussed the foundation of market efficiency to exist on satisfaction of any of the three conditions that are 'Rationality', 'Independent deviation from Rationality' and 'Arbitrage' (Andrei Shleifer). Our research also gives answer to the question that how prices incorporates the various types of information given in different sets i.e. Weak, Semi-strong and Strong forms. Behavioral Finance models such as prospect theory, expected utility theory, overconfidence, over and under reaction, mental compartments, Disjunction effect and limits to arbitrage are also studied as none of the three conditions given above satisfies in reality and hence explained as anomalies of market efficiency. The three different trading strategies i.e. Momentum, Contrarian and Technical are also analyzed but only momentum and contrarian are much preferred by the academics and investors.

Keywords: Behavioral Models, Outperformance, Anomalies, EMH

INTRODUCTION:

Incorporation of information in the stock prices leads to the explanation of what is called as "Efficient Market Hypothesis" (Harry Roberts (1967)). In other words, "this is the hypothesis that financial prices efficiently incorporates all public information and the prices can be regarded as optimal estimates of true investment value at all times" (Shiller (2001)). Research is done in considering the adjustment of the security prices to three information subsets namely 'Weak form tests (Information about Historical Prices)', 'Semi-Strong form tests (Publicly available information)', 'Strong form tests (All Information)' (Fama (1970)). According to Shiller (2001), Efficient Market Hypothesis is based on the ancient belief of investors being rational by processing all available information for maximizing the expected utility. On the contrary according to Mackay (1841), a feeling of something "egregiously wrong" with the concept of Efficient Market Hypothesis can be felt. This brings us to the explanation of what is called as 'Anomalies of Efficient Market Hypothesis' because the principle of rational behavior of investors is not entirely correct and has to be studied along with the other human behavior models like prospect theory, expected utility theory (Theories of human behavior), overconfidence, over and under reaction, mental compartments, disjunction effect (Cognitive Psychology or anomalies) etc. and limits to arbitrage (inefficient markets). The last part of this research also covers the different trading strategies that are: Momentum, Technical and Contrarian strategies.

EFFICIENT MARKET HYPOTHESIS:

Many researchers defined "EMH" in the similar fashion as, "Market in which security prices fully incorporate or reflect any available information" (Fama (1970)). Now we'll illustrate an example to understand the true timings of new information into the security prices and its implication (Ross et al. 2008). Suppose XYZ Car Company Ltd. plans to launch a car that should run on dual fuel and expects to have a minimum per kilometer cost of running. In an efficient market, the share price is expected to rise for this Company, if it is likely to have a monopoly in that technology. Now the next question arises that when will be the rise in share prices expected? Let us assume that the news related to the Car manufacturing and its new technology, is released on Thursday morning. …

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