From the Efficient Market Hypothesis to Behavioral Finance: How Investors' Psychology Changes the Vision of Financial Markets

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From the Efficient Market Hypothesis to Behavioral Finance
How Investors’ Psychology Changes the Vision of Financial Markets by ADAM SZYSZKA

Poznan University of Economics Poland adam.szyszka@ae.poznan.pl

I. Introduction

The efficient market hypothesis (EMH) has been the key proposition of traditional (neoclassical) finance for almost forty years. In his classic paper, Fama (1970) defined an efficient market as one in which “security prices always fully reflect the available information” [p.383]. In other words, if the EMH holds, the market always truly knows best. Until the mid-1980s the EMH turned into an enormous theoretical and empirical success. Academics from most prestigious universities and business schools developed
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But even if irrationality becomes common for a relatively large group of investors who act in a correlated manner, and therefore are able to move prices away from fundamental levels, it is assumed that rational arbitrageurs will quickly notice the mispricing and act appropriately. By selling the overpriced asset on one market and buying the same or similar asset on the other cheaper market, they will create additional market forces that will bring asset prices back to equilibrium levels. It is assumed that there are many rational arbitrageurs who act quickly and without any constrains.

Electronic copy available at: http://ssrn.com/abstract=1266862

The argumentation in favor of the EMH seems quite appealing. In short, it follows like that: When all people are rational markets are efficient by definition. When some people are irrational, their behavior is usually uncorrelated and the impact of their trades is too weak to influence prices. Finally, when sometimes irrational investors behave in a correlated manner (like a herd) and they sometimes have enough of a market force to drive the prices away from fundamentals, then active and unlimited trades of rational arbitrageurs will countervail and bring the prices back to right levels. The EMH is closely related to two other cornerstones of neoclassical financial economics: the Capital Asset Pricing Model (CAPM) developed independently by Sharpe

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