Question

Some people argue that the efficient markets hypothesis cannot explain the 1987 market crash or the high price to earnings ratio of internet stocks during the late 1990s. What alternative hypothesis is currently used for these two phenomena?

Answer 1

• Behavioral finance theory is an alternative model in which individuals are considered as normal and not reasonable.
• It suggests that investors appear to have certain emotional and psychological biases which results in irrationality.
• According to EMH, investors do not purchase undervalued commodities or sell assets for inflated rates, which is the opposite of what happened in the 1987 and 1990s market crash.
• When the market came down in 1990s, most investors sold their assets at very unreasonable prices due to fear of the crisis.
• The behavioral finance theory explains what happened in 1990s and 1987.
• Behavioral finance tries to explain both the 1987 stock market crash and the Internet bubble by changes in investor sentiment and psychology.
• These changes can result in non-random price behavior.

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