Efficient Market Theory & Behavioural Finance with regard to Financial Essay

Efficient Market Theory & Behavioural Finance with regard to Financial Crisis 2007-2010 - Essay Example Behavioural Finance is a blend of psychology with finance, a contribution by Psychologists Daniel Kahneman and Amos Tversky, along with Richard Thaler, a University of Chicago professor and his colleague Nicholas Barberis. Their works have encouraged many scholars to pursue research in this unusual and different-from-classical-approach field. In this paper, there is the analyses of the two theories, the causes of the Financial Crisis and if EMH has direct implications in it. There is an explanation how behavioural finance can explain the anomalies which have persisted too long to lead to this crisis situation. Analysis Efficient Market Hypothesis A market is efficient with respect to the available information set if the market prices fully reflect that information (Fama, 1970, p.383). Therefore, in an efficient market it is impossible for investors and portfolio managers to earn excess returns by holding a portfolio of randomly selected stocks with comparable risks. The efficient mar ket hypothesis is based on the Random Walk Hypothesis, which states that the changes in a stock’s price are a random departure from its previous price. The set of assumptions, which imply an efficient capital market, are: 1. A large number of profit-maximizing investors analyze and value the security independently of each other. 2. New information regarding a security comes in a random manner. 3. The investors adjust security prices quickly to reflect the new information. Efficient Market Hypothesis has three forms- Weak form Efficiency, Semi strong form Efficiency and Strong form Efficiency. In the Weak form efficiency, historical prices are irrelevant in predicting future prices and therefore, cannot earn excess returns from the investment strategies based on historical data. In Semi strong form efficiency, share prices quickly reflect the publicly available information in an unbiased manner; therefore, it is impossible to earn excess returns from fundamental analysis or te chnical analysis. In strong-form efficiency, share prices reflect both public and private information and it is impossible to earn excess return, provided there are no barriers for private information to become public. The idea behind EMH, which is very simple, is that the competition enforces revenues and costs to come into equilibrium, new entry eliminates the excessive profits, if any, and the asset prices are a function of flow of information to the financial markets (Ball, 2009, p.9). Evidence in Support of EMH: Eugene Fama conducted the strong-form tests to know whether the investors had any monopolistic access to the information relevant to the security’s price (Fama, 1970, p.383). In 1991, Fama gave his second review of EMH in which he found that instead of weak-form tests, the first category now covers more areas of tests for return predictability (Sewell, 2011, p.5). In his third review, Fama concluded that market efficiency survives the challenge from the literatur e on the long-term anomalies (Fama, 1998, p.283). In his paper â€Å"The Efficient Market Hypothesis and its Critics†, Malkiel examines the criticism of EMH and concludes that the capital markets are efficient and less predictable (Malkiel, 2003, p.77). In Figure 1 Malkiel has calculated the percentage of actively managed funds,