How does behavioral finance explain the real world inconsistencies of the efficient markets hypothesis (EMH)?

Expert Solution

Answer: Behavioral finance is the sentiments of investors related to stock market. It explains the efficient market hypothesis.

Efficient market hypothesis- This approach says that it is impossible to beat the stock market and gain excess returns. No fundamental and technical analysis exactly work here, one news is enough to bring the stock market down. It says, stocks are always trade at fair value, investors purchase undervalued stocks and sell them at higher price.

Inconsistencies of the efficient markets hypothesis- Are as following:

Volume- If investors are rational, they do not trade too much. They trade too less with the help of publicly available information.

Volatility- From the efficient market point of view, Price of a security changes only when there is dividend expectation or any new information arrives.

Cash dividend- Cash dividends are subject to higher income tax. When a company announces cash dividend, stock price rises and after paying the cash dividend, stock price falls so it has been an important indicator to determine the market price of stock.

Equity premium puzzle- Stocks provide higher premiums than treasury bills then why don't people invest all their savings into stocks?

Predictability- As per EMH, it is not possible to predict future prices but there are some indicators that can predict future prices of stocks. These indicators are: Dividend yield, price earning ratio, price to book ratio etc.

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