Question

Research has shown in the past that high B/M stocks generally have higher average returns than low B/M stocks over long periods of time. Explain how efficient market hypothesis and behavioral finance would differ in their explanations of this phenomenon.

Answer 1

According to efficient market hypothesis below is the explanation:-

• High B/M stock called value stocks are usually from well established companies- thus offers lower level of risk and volatility comparatively - thus they also usually gives dividends - hence would lead to higher avg returns than low B/W stock (growth stocks)
• Even if adverse news affects the Value stocks it wont be for longer time

According to the behavioral finance below is the explanation:-

• Investor’s risk tolerance, investment objective and time horizon will matter a lot ,
• Growth stock if considered to be undervalued generally comes from fundamental stock analysis whereas Value stocks depending upon the financial ratio or benchmark that it is being compared to
• Thus even in this scenario High B/M stock called value stocks are usually from well established companies-their financials will be solid depicting higher avg returns as compared to growth stocks