Question

1. Many of the concepts you have studied in finance rely implicitly on efficient markets, i.e., capital budgeting, the relationship between risk and return, asset allocation and even the rule that managers should try maximize shareholder wealth. However, there is a great deal of evidence over the last 30 years that markets may not be efficient and thus these concepts may not hold empirically. Take one idea from what you learned in behavioral finance use it to explain why markets may not be efficient.

Answer 1

Ans. Market Efficiency refers to the degree to which market prices reflect all available and relevant information. If markets are efficient then all th information is already incorporated into prices and so there is no way to beat the market because there are no undervalued and overvalued securities available.

However, markets may not be efficient as according to behavioural finance there are inherent biases in the way individual interpret information. This can be understood by one of the concept of Behavioural Finance i.e.

ERRORS IN INFORMATION PROCESSING:

According to the behaviour finance, if there are errors in information processing, then it can lead investors to estimate incorrectly the true probability of events. For example, while forecasting, some people give too much weight to the recent experience compare to the prior belief when making forecasts.

So, a market is said to be efficient if it reflects all the relevant information but if that information interpreted by the investor wrongly then the market is no longer said to be efficient.