Question

a) Briefly explain the concept of market efficiency.

b) The textbook describes the field of Behavioral Finance as the study of “how reasoning errors influence financial decisions.” The textbook also contains a good discussion of how cognitive errors, biases and heuristics lead to irrational decisions by investors. What implications does all this have for stock market efficiency? Discuss.

Answer 1

1. Efficient market hypothesis:

The security prices already reflect all the available information.

The efficient market hypothesis says that past price movement, earnings report and volume traded doesn't affect stocks Current price and can't be used to predict the stocks future directions.

In simple words, past performance doesn't guarantee the future performance of the stock price moment. The stock price follows a Brownian motion. That is stock price moment is random that's why it's also called a random walk theory.

They are 3 levels of Market efficiency:
1. Strong efficiency: Insider information, fundamental analysis and technical analysis are unless in such a market.
2. Semi- Strong: fundamental analysis and technical analysis are unless in such a market.
3. Weak: technical analysis is unless in such a market.

Thus in an efficient market: the market value would represent the true value of an asset.

Extra: just for help.

2. Efficient market hypothesis State State people are directional investors which is an important part of the financial market.
The Behavioural Finance States that investors have a drawback due to some psychological and emotional biases which lead to irrational market and decisions.
Behavioural Finance contradicts the efficient market hypothesis theory in a way that people are normal and irrational, they take decisions on the emotions which leads to errors & influence financial decisions.