From the Efficient Market Hypothesis to Behavioral Finance: How Investors' Psychology Changes the Vision of Financial Markets Essay

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Pages: 23

From the Efficient Market Hypothesis to Behavioral Finance
How Investors’ Psychology Changes the Vision of Financial Markets by ADAM SZYSZKA

Poznan University of Economics Poland

I. Introduction

The efficient market hypothesis (EMH) has been the key proposition of traditional (neoclassical) finance for almost forty years. In his classic paper, Fama (1970) defined an efficient market as one in which “security prices always fully reflect the available information” [p.383]. In other words, if the EMH holds, the market always truly knows best. Until the mid-1980s the EMH turned into an enormous theoretical and empirical success. Academics from most prestigious universities and business schools developed
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The CAPM states that the relationship between the expected return and the amount of systematic risk is linear. Early empirical tests of the CAPM gave relatively good results, despite the fact that the model had been derived under many rigorous and unrealistic theoretical assumptions. However later studies, covering longer and wider time series of data, are far less convincing and rather contradict the original version of the CAPM. This leads to so called dual hypothesis problem. If the empirical tests do not confirm the CAPM we cannot be sure if the model is wrong or maybe the market is not efficient. The current view within the school of traditional finance attempts to defend market efficiency suggesting that there might be other factors, beside the beta – that measure the amount of undiversifiable market risk. The three-factor model of Fama and French (1992, 1993, 1996) is the best known example in this vein. The main problem with these new models is that they are based on regressions that are designed to fit the data. Their theoretical background is very discussible. The same models, but interpreted differently, are often used by the behavioral school in the argumentation against market efficiency. But let us stay at this point of the