The Fama Critique Compared to New Research

The Fama Critique Compared to New Research

1. Introduction

Over the last couple of decades there has been a debate going whether or not there are behavioral aspects in finance. This means that financial markets are subject to different investors’ sentiments and that markets are not efficient, i.e. the efficient market hypothesis (EMH) does not hold. The supporters of EMH argue that all available information is included in the stock prices, which means that any long-term abnormal returns earned are a matter of chance. On the other side, the supporters of behavioral finance argues that because of over- and under-reaction by investors to information, it takes time before prices fully adjust and thus there is an opportunity to earn long-term abnormal returns.

In 1998 Eugene F. Fama published a famous critique on long-term return anomalies. He infers that all anomalies that was pointed out in scientific papers up until then where a matter of chance. His argues that it is easy to show the weaknesses of behavioral models and proof of anomalies. If there is a more or less even split between over- and under-reaction, and continuation and reversal of returns, then this supports the market efficiency hypothesis that any abnormal returns are chance. He also infers that with a reasonable change in methodology used, the anomalies are severely reduced or disappears completely.

In the years after his critique was published there have been a lot of papers contradicting Fama’s view and giving support to the behavioral aspect of finance, saying that EMH is not valid for financial markets due to over- and under-reaction by investors due to overconfidence. In this essay I am going to look closer at two papers which focus on how investors’ different reactions to information increases trading volume on the market (Odean, 1998) and which stocks are traded (Barber and Odean, 2007) . These both find evidence that the over-reaction of investors to certain information influence their trading and thus the market. This contradicts the theory of an efficient market where all reactions in the market are rational.

I will first present some brief theory on the Efficient Market Hypothesis and behavioral finance. Then I give an overview of the critique by Fama (1998). In the next section I will present the main points of the articles by Odean (1998), and Barber and Odean (2007). These are then compared to the relevant conclusions of Fama.

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