Question

Describe the three forms of the Efficient Markets Hypothesis and explain the behavioral finance critique of market rationality.Be sure to include evidence of why markets could be considered efficient and why they could be considered inefficient. Conclude by explaining if you feel markets are efficient, emphasizing why you feel that way.

Answer 1

The three forms of efficient market hypothesis is :

• Weak form : this form of market efficiency states that the past stock prices cannot predict the future stock prices as the stock prices follow a random pattern. Technical analysis is useless in a weak form of market efficiency. All the information about the stock price, volume is completely incorporated in the stock prices.
• Semi-strong form of market efficiency : this form of market efficiency states that , all the public information is completely incorporated into the stock prices. The investors can only make profits on the basis of any insider information. The fundamental analysis is of no use in a semi strong form of market efficiency.
• Strong form of market efficiency : in this form of market efficiency, the investors cannot make profits by either the public information or the insider information. All the information both public and insider is incorporated into the stock prices.

Behavioral finance states that the investors are not always rational and they sometimes take certain decisions based on emotions and biases.

One example is the loss aversion bias : When an investor is affected by this bias, they keep on holding a loss making position in the hope that it might recover sometime in the future. Although the company is making losses and the financials are weak, still the investor is holding on to it in the hope that it may rebound.

I don't believe thar the markets are efficient. If at all the markets were efficient then the investors would not be able to make profits at all. There would have been no undervalued or overvalued securities and all the stock prices would completely incorporate all the information.

As investors we make profits by identifying the undervalued securities using fundamental analysis and buy those securities and sell the overvalued securities. We also use technical analysis to predict the future price movements , so i don't believe that the markets are efficient. Mutual funds generate an alpha by creating active portfolios and generate higher returns than the market index.