Behavioural Finance and the Efficiency of Capital Markets Essay

Behavioural Finance and the Efficiency of Capital Markets - Essay Example All the literature on market efficiency defines an efficient market as one where prices reflect all available information and sellers cannot earn windfall profits in a sustained manner (Fama, 1970). Large profits can be earned only by having inside information that is not publicly known and trading based on such information, or through misinformation; both are illegal. In an efficient market, assuming all companies disclose information to investors, only those who enter the market first may earn above average returns. Just like any other market, the one who arrives first can buy at a lower price and then, as demand goes up, sell at a higher price. This logic that consistently beating the market is not possible led to the creation of index funds that mimic the market's performance. Nevertheless, small investors unaware of these academic and empirical discussions continue to try to beat the market, only to incur expenses on fees and commissions. Behavioural finance proponents think that market-beating strategies exist and that a careful analysis of historical price trends and financial reports can pay off (Shiller, 1990). They point to stock market anomalies and other forms of market inefficiencies that allow investors to reap above average returns. He claims that conclu... Nevertheless, small investors unaware of these academic and empirical discussions continue to try to beat the market, only to incur expenses on fees and commissions. Behavioural finance proponents think that market-beating strategies exist and that a careful analysis of historical price trends and financial reports can pay off (Shiller, 1990). They point to stock market anomalies and other forms of market inefficiencies that allow investors to reap above average returns. So going back to our question: are markets efficient Fama (1998) thinks it is and that it continues to be so as proven by empirical studies (Fama and French 1992, 1993, 1996 and Malkiel, 1995). He claims that conclusions based on market anomalies discovered by behavioural finance are due to poorly done statistical work (1998, pp. 292-294) and amateurish techniques (1998, p. 296). He cited (1998, pp. 288-290) above average returns as the result of chance, that behavioural finance models are loaded with judgmental biases making it predictably easy to justify any hypothesis proposed, and that the efficient market hypothesis can explain all forms of market behaviour to date. Behavioural finance supporters Barberis, Shleifer and Vishny (1998) claim that an ongoing battle between rational and irrational traders exists in the market, with the irrational ones dominating. The systematic errors that irrational investors make when they use public information to form expectations of future cash flows overwhelm the efforts of rational traders to undo the former's market dislocating effects. Daniel, Hirshleifer, and Subrahmanyam (1998) state that irrational traders' overconfidence in interpreting