The Efficient Market Hypothesis

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1. INTRODUCTION The efficient market, as one of the pillars of neoclassical finance, asserts that financial markets are efficient on information. The efficient market hypothesis suggests that there is no trading system based on currently available information that could be expected to generate excess risk-adjusted returns consistently as this information is already reflected in current prices. However, EMH has been the most controversial subject of research in the fields of financial economics during the last 40 years. “Behavioural finance, however, is now seriously challenging this premise by arguing that people are clearly not rational” (Ross, (2002)). Behavioral finance uses facts from psychology and other human sciences in order to explain human investors’ behaviors. 2. MAIN BODY A generation ago, it was generally believed that security markets were efficient in adjusting information about individual stocks and stock market as a whole (Malkiel, (2003)). However, we cannot deny the efficient market hypothesis has several paradoxes. In the first place, a main theoretical cornerstone for the EMH to be a consequence of equilibrium in capital markets is that markets are always rational. This is against the realism. Even if the foregoing assumption turn out to be entirely possible, many recent studies have concluded that rationality is not always a realistic assumption as investors in many cases engage in irrational investment (Kahneman and Riepe, (1998)). Second, the efficient market hypothesis cannot explain market anomalies. These market anomalies include the pricing/earnings effect, the size and January effect, the monthly effect, holiday effect and the weekend effect. These anomalies indicate either market ineffici... ... middle of paper ... ...el, 2003. The Efficient Market Hypothesis and Its Critics, Journal of Economic Perspectives, Vol. 17, No. 1, Winter 2003, pp. 59-82. [12]. Jay R. Ritter, 2003, Behavioral Finance, Pacific-Basin Finance Joural 11 (2003), pp. 429-437 [13]. Stephen A. Ross, 2002. Neoclassical Finance, Alternative Finance and the Closed End Fund Puzzle, European Financial Management, Vol. 8, No. 2, 2002, pp. 129-137 [14]. G. William Schwert, 2002. Anomalies and market efficient, NBER Working paper No. 9277, Oct 2002. JEL No. G14, G12, G34, G32 [15]. Andrei Shleifer and Lawrence H. Summers, 1990. Journal of Economics Perspectives, Vol. 4, No. 2, Spring 1990, pp. 19-33 [16]. A Discussion with Burto Malkiel and Sendhil Mullainathan, 2005. Market Efficient versus Behavioural Finance, Journal of Applied Corporate Finance, Vol. 17, No. 3, A Morgan Stanley Publication, Summer 2005
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