Question

Can behavioral finance be used to justify the critique of the efficient market hypothesis? Provide reasons.

Answer 1

The major critique of the efficient market hypothesis is that market prices fluctuate too much in the short term and they do not reflect the fair value of the security. This is correct however if you look at the stock prices in the long term the stock price is closer to the intrinsic value of the security. The short-term fluctuations are because of the buying and selling pressure created by the traders and can be looked at it from the perspective of human behaviors. The two most significant emotions that any human being shows are greed and fear and this behavior cause the intra day traders to follow the sentiments in the market. If there is sudden news and some traders sold their position and more traders will follow that because they expect that the stock price will fall more even when because of a certain news there is no significant change in the intrinsic value of the security. This can be called herd mentality. Herd mentality is when you are following a group whether they are right or wrong does not matter to you. This fear and greed pattern in the market causes significant fluctuation in the prices and increases the volatility further deviating away from the efficient market hypothesis.