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A market is said to be efficient with respect to information if the price ‘fully reflects’ all
available information regarding securities. Efficient Market Hypothesis (EMH), one of the
most eminent and influential of modern financial theories, assumes that all relevant
information is rapidly incorporated in security prices as released. However researchers and
investors disagree with EMH both empirically and theoretically. The emergence of Behavioral
Finance (study of finance from the perspective of psychology and sociology) by the start of
21st century has opened new avenues of research. The focus of discussion shifted from efficient
market model to the behavioral and psychological aspects of market players. It comprehended
that unlike traditional economic theory, psychological theory could account for the
irrationality and illogicality in behaviors. It is claimed that stock prices are predictable and it
is possible to consistently and purposefully outperform a given market using these predictable
patterns. The ‘Stock Market Crash of 1987’, when the DJIA fell by over 20% in a single day,
also empirically contradicted EMH.
Supporters of behavioral finance attributed market inefficiency to the combination of
conventional economic and financial theory with behavioral psychological theories and
cognitive biases like personal judgment, overconfidence, overreaction, expectations regarding
future, word-of-mouth optimism/pessimism, ego involvement, self-esteem and self-attributed biases. Calendar effects, predictable patterns of valuation parameters (P/E and B/MV ratios),
short-term momentum and tendency of returns to reverse over long run also contradict
EMH. EMH was mostly attacked on the grounds of the speed with which information is
supposed to reach market players. Critics argued that information cannot be readily
incorporated in security prices as assumed by EMH. Empirical evidences, though, have shown
mixed results, not strongly supporting EMH.
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