Question

Critically analyze the Efficient Market Hypothesis and Behavioral Finance. In your opinion, which one presents a more realistic description of the capital markets? Why?

Answer 1

Efficient Market Hypothesis suggests that there are three forms of market efficiency - weak form of efficiency where there is no much information priced into the stock market, a semi-strong form of efficiency where there is some part of public information priced into the capital markets and a strong form of market efficiency where all information is considered in the stock prices. Markets are always in the semi-strong form since there would be some information that is not factored in.

In behavioral finance, we talk about two factors "Greed" and "Fear". When the stock market moves up, the "Greed" in our minds takes over and we are in a rush to buy the stock assuming that they are going to zoom ahead. This situation occurs in a bull market. On the other hand in a bear market, when the prices of stock fall, investor get into the "Fear" mode and start selling as if there is no tomorrow.

In my opinion, the behavioral finance is more realistic and that is what happens to the stock prices. The more prudent thing to do is to "Buy when there is Fear and Sell when there is Greed" which is most difficult to do.