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

However, markets may not be always efficient as they are influenced by the Behavioural concepts of finance, such as:

Errors in information processing: If there are errors in the information processing then it can lead the investors to misinterpret the true value of the probability events. For example, during forecasting, sometimes people give too much weight to the recent experience compared to the prior beliefs when making forecasts.

Also sometimes investors in their overconfidence tends to overestimate their predictive skills and believe that they can time the market, which in turn results in the losses.

Therefore, markets may not be efficient due to the behavioural aspects of the investors involved in making their financial decisions.