In this research paper, we examine the distinct theories of traditional and behavioural finance, linking them to efficient market hypothesis. The scope of the paper covers market anomalies as well as behavioural biases of individuals/analysts and the impact of such on portfolio construction. Over the last two (2) decades, behavioural finance has been growing steadily. This growth is associated with the realization that investors rarely behave according to the assumptions made in traditional finance and economics.
Traditional finance can be regarded as theories which are currently accepted in academic finance, in which the foundation is based on modern portfolio theory and the efficient market hypothesis. (Baker, 2013)Traditional finance has served to be the dominant paradigm for decades in which investors are guided with regards to decision making.
In congruent with the traditional finance theory, the efficient market hypothesis is one of the most accepted theories by academic financial economist. This hypothesis postulates that markets will perform efficiently when there are large numbers of rational profit maximizing investors, who are competing amongst each other in the aim to predict future market values of individual securities. For efficient markets to operate, it is critical for current information to be available at no cost for all investors. The latter was postulated through tests performed by Manderlbort and Samuelson. Furthermore, Fama et al. (The father of modern finance) performed tests to determine whether stock markets are efficient with regards to how quickly they react to new information. The effect of stock splits on prices was studied by Fama et al. and from their observations, it was concluded tha...
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...aturdays and Sunday. Under the efficient market hypothesis there should be no difference with regards to the day of the week.
Also observed is the holiday effect where there are unusually high stock returns before stock market holidays. A plausible explanation for this is that on a holiday people feel pleasurable which leads to a high purchasing power and as a consequence the high returns for the day before the holiday.
With these anomalies that are present within the efficient market hypothesis, the question becomes should we negate the efficient market hypothesis with regards to portfolio construction or should behaviour finance be seen as an alternative to the efficient market hypothesis.
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