Efficient Market Hypothesis v’s Behavioural Finance
An efficient market is one in which share prices quickly and fully reflect all available information, where investors are rational, and there are no frictions. Investors determine stock prices on the basis of expected cash flows to be received from a stock and the risk involved. Rational investors should use all the information they have available or can reasonably obtain, including both known information and beliefs about the future. In an efficient market there is “no free lunch”: no investment strategy can earn excess risk-adjusted average returns, or average returns greater than are warranted for its risk (Barberis, 2003). Market efficiency is assessed by determining how well…show more content… Thus as a result the mispricing can remain unchallenged leading to market inefficiency.
The Size effect is the observed tendency for smaller firms to have higher stock returns than large firms. A study by Banz (1981) found that on average stocks of small NYSE firms earned higher risk-adjusted returns than the stocks of large NYSE firms. Although much of the differential performance is merely compensation for the extra risk of small firms, it has been argued that not all of it can be explained by risk differences. Keim (1983) presented evidence that most of the difference in performance occurs in the month of January. This, known as the January Effect is the observed tendency for returns to be higher in January than in other months. Keim (1983) studied the month to month stability of the size effect for all NYSE and AMEX firms with data for 1963-1979 and his findings again supported the existence of a significant size effect, with roughly half of the size effect occurring in January. The January effect poses a significant problem for the EMH since it seems to point to a simple opportunity for investors to make excess profits; that is to buy small company stocks towards the end of December and sell them at the end of January (Pilbeam, 2005, p.256).
A number of papers have argued that equities with high book value to share price ratios and/or high earnings to