Question

Research documents that firms with high historical returns in the last six months will continue such performance in the next six months, which is termed as momentum in literature. How will you explain this finding if you believe in EMH? What will be your explanation if you believe in behaviour finance?

Answer 1

Efficient market hypothesis advocates that all the publicly available information and the privately available information have already been discounted into the stock price and there is no scope of making a higher rate of return than the index, so when historical returns are reflecting that funds will be making a higher return, then it will be against the Efficient market hypothesis as Efficient market hypothesis will be advocating for passive investment and they will be advocating for lower rate of return than index. Hence it can be said that this outperformance is not in line with Efficient market hypothesis as Efficient market hypothesis does not offer with higher rate of return than the index rate of return.

Behavioural finance will be suggesting investment based upon the behaviour and it will be trying to act upon various human behaviourial traits in order to invest their money into the market and make a higher rate of return and they will be believing that they can outperform the market by studying trends and doing fundamental analysis as well as technical analysis, so outperformance of these funds to the market index return is in line with the behavioural Finance.