Efficient market hypothesis vs behavioural finance

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Efficient market hypothesis vs behavioural finance

Alternative Asset Pricing Models 4. Fama-French and Carhart 5. Influence of Psychology on Risk and Return 5. The chance to lose is underestimated by most people.

Two centuries later the behavioural economist Daniel Kahneman confirmed the notion that in situations with uncertainty people are inclined to biased decision-making. Actual tests of the CAPM on stock data confirmed that the market premium as a single factor may be insufficient to explain stock returns completely.

These models were in some respects more accurate than the CAPM in predicting future returns; however, it remained unclear why these factors actually matter. So why may investors act irrationally? Do these effects arise from investors whose emotions, biases or believes affect their decision-making process?

Is the existence of property cycles consistent with the Efficient Market Hypothesis? KF Man1, KW Chau2 Property Cycle, Efficient Market Hypothesis, Behavioural Finance 1The Hong Kong Polytechnic University 2University of Hong Kong Concurrently, Behavioural finance school emerges and raises a different viewpoint on the market efficiency. Efficient market hypothesis (EMH) is founded on the theory of expected rationality but the theory of behavioural finance concludes that stock market investors are quasi-rational. Efficient Market Hypothesis And Behavioral Finance—Is A Compromise In Sight? 2 Figure 1. Simulated stock price path Those somewhat acquainted with technical patterns might recognize a .

What additional factors should we add to our model to explain risk and return in real-life? This paper will analyze the current research about the affect heuristic, biases and emotions and explore the explanatory power of these effects on future stock returns.

As John Nash formulated it: Although behavioural finance provides explanations why people make biased decisions in situations involving uncertainty, this qualitative knowledge is difficult to incorporate in models.

Section 2 will depict the current state of research in regard to the validity of the CAPM by evaluating the evidence of anomalies.

Andrei Shleifer

In section 3 several alternative models will be evaluated. Section 4 will present reasons why these anomalies exist in light of the behavioural finance view.

In section 5 I will discuss both approaches and conclude in section 6 with my opinion and recommendations for further research. It built the foundation of modern finance assuming risk-free borrowing and lending as well as rational decision-making.

If the CAPM holds true, the systematic risk, i. A beta of one would imply that the stock moves one-to-one with the market portfolio, while a beta of two would imply that the stock moves twice as much as the market portfolio. However, if the beta is zero, the stock is not correlated at all to the market portfolio and stock returns will follow a random walk.

Furthermore, if the CAPM shows to be valid, we expect i the intercept to be equals zero, and ii the market premium to be positive. Now let us have a look at the origins of the theories of efficient markets and perfect rationality.

Her fixed preferences and perfect information set enables her to react immediately to changes in the environment. In finance, she would want to own traditional mean-variance efficient portfolios to maximize stock return, while minimizing volatility, following the Efficient Market Hypothesis EMH developed by Fama in the early s.

Since markets are efficient, stock prices should reflect all available information immediately. The efficient market hypothesis was shown valid by researchers asserting that prices do follow a random walk, while incorporating all available information instantly Samuelson, Furthermore, Fama and Sharpe among others have shown statistically significant results that not only depict a positive relationship between beta and the market premium, but also exhibit a strong internal consistency between the EMH and the CAPM.Market efficiency survives the challenge from the literature on long-term return anomalies.

Consistent with the market efficiency hypothesis that the anomalies are chance results, apparent overreaction to information is about as common as underreaction, and post-event continuation of pre-event abnormal returns is about as frequent as post-event reversal.

Efficient market hypothesis vs behavioural finance

In finance, she would want to own traditional mean-variance efficient portfolios to maximize stock return, while minimizing volatility, following the Efficient Market Hypothesis (EMH) developed by . The emerging theory of Adaptive Market Hypothesis tries to assimilate Efficient Market Hypothesis into the behavioural finance realm, borrowing heavily on the laws of evolution of competition, adaption and natural selection.

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European Journal of Social Sciences – Volume 7, Number 2 () 7 Efficient Market Hypothesis and Behavioural Finance: A Review of Literature. The battle between proponents of the Efficient Markets Hypothesis and champions of behavioral finance has never been more pitched, and there is little consensus as to which side is winning or what the implications are for investment management and consulting.

In this article, I review the case for. Efficient market hypothesis (EMH) is founded on the theory of expected rationality but the theory of behavioural finance concludes that stock market investors are quasi-rational.

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