Comment on the Three Conditions on Market Efficiency

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An efficient capital market is one in which stock prices fully reflect available information. Professor Andrei Shleifer has suggested three conditions lead to market efficiency. (1)rationality, (2)independent deviations from rationality, and (3)arbitrage. This essay will examine investors’ behavioral biases and then discuss the behavioral and empirical challenges to market efficiency.

In the attached article, James Montier suggested three behavioral biases that investors had. (1) illusion of control, (2)self-attribution, and (3)over-confident. Illusion of control means people fell they are in control of a situation far more than they are. Self-attribution means good outcomes are contributed to their skill while bad outcomes are
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People are too slow in adjusting their beliefs to new information. In 2005, Kolasinski and Li have done a research by ranking companies by the extent of their earnings surprise. They found that prices adjust slowly to the earning announcements with the portfolio with the positive surprises outperforming the portfolio with the negative surprises. Behavioral finance suggests that investors exhibit conservatism.

Professor Andrei Shleifer suggests that domination of rational professional will carry the stock meet its efficient prices by simultaneous purchasing and selling of misprice stock. However, in a world of many irrational amateurs and a few professionals, prices would not adjust to correct level. The risk of further mispricing may reduce the size of arbitrage strategies. In 1907, Royal Dutch Petroleum and Shell Transport merge interest and split the cash flow in a 60/40 basis. However, empirical finding shows that two parties have rarely traded at parity (60/40) over the 1962 to 2004 period. Deviation from parity could increase in the short run, implying losses for the arbitrageur.

There are also a numbers of empirical challenges to market efficiency. The common features among those empirical studies were all in an international basis.

A number of studies of relationship between the return and its market capitalizations have been replicated over different periods and in different countries. They found that return on

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