Behavioral Finance vs Efficient Market Hypothesis

This assignment delves into the contrasting perspectives of behavioral finance and the efficient market hypothesis. It examines how behavioral biases influence investor decision-making, challenging the traditional assumption of rational investors within the framework of the efficient market hypothesis. The assignment analyzes various academic papers and research to illustrate the implications of behavioral finance for investment strategies and market efficiency.

Running Head: Investment Management
Investment Management
Behavioral Finance

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Introduction
Behavioral Finance and investment management goes hand in hand as both are related to
managing the Finances (Ritter, 2003). Investment management is a process where funds are
managed. It shows as to how can a investor make decisions about investing his money (Stanlay,
2011). While, Behavior management brings together some economy principles which influences
psychology of a human behavior while making investment decision. Intention of both of these is
to help us make better choices. It involves already imbibed beliefs that make the person bias and
these beliefs then hinder the decisions of a person. The concept of efficient market hypothesis is
now a part of new modern finance. It is a sound concept in terms of finances. It can be applicable
for the capital markets which are linked with the efficiency of cost and the other markets are also
analyzed. It deals in the stock market where prices of market show the information about the
companies. In other terms, the efficient market hypothesis is a theory of framework which helps
in investing when human is going through behavioral finance (Malkiel, 2003).
Behavioral Finance challenging the Efficient Hypothesis
The Efficient Market Theory has been the only managing and controlling theory of management
from many years. Later when behavioral finance came into picture; it challenged the assumptions
of Market hypothesis, particularly related to the investment concept. It has involved psychology
and emotions into investment behavior theory. Also there are shortcomings of Efficient Market
Hypothesis which were pointed out buy the Behavioral Finance and also at the same time, it
should be taken positively with respect to stock market studies (Sharma, 2014). The major
challenges are the following:
1. Availability and access to information
Efficient Market Hypothesis states that the investment markets are sufficient with the
information. Everyone can access the information whenever they need and due to this news
of investment cannot be manipulated. Although, this statement faces challenges on the basis
of two things: access and availability. From the theory point, everyone has access to only the

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investing information and not on the practical information. Due to daily lifestyle, everyone
has different time to access to information. Availability of the information is also a weakness
for EMH. Generally, the investment information is available to only top speculators or to the
limited group of people who are investing and then at the later stage, it is shared with the
public. Hence, the one’s who get the information early take the advantage from this. Also,
the major emphasis should be given to the on to the method by which the information is
communicated rather than the availability of information. In the same context, behavioral
finance says that stock markets are inefficient in information in terms of availability and
access (Akintoye, 2008).
2. Fundamental Analysis
The methods that help in making investment decisions usually are of two categories:
Technical and fundamental analysis. In investment process, if investors want to establish
good and profitable relationship with the company, it should apply fundamental components.
It’s the tendency of the investor to create a picture of the company in their portfolios when an
investor is interested in the financial data of the company. Due to this they encourage
relationships very confidently with the company they are interested in. In EMH, fundamental
analysis is limited. Followers of the EMH, created issues supporting it and due to this, it was
taken as a paradoxical theory and at last, concluded with refuting it.
3. Technical Analysis
EMH refutes the technical analysis, when the direction of prices on the study of past data
forecasting is done. Due to this, the impact on the investment decision making lies because of
the historical development of the company. Past data should not be just the focus for the
research when one needs to achieve high returns. Past data should only be treated as a
memory.
4. Uniformity of Investment
As stated by EMH, the people who are very much into the stock market and investment, they are
looked as the colorless groups of people those who share the same attitudes, traits, methods and
scope. Family or friends, experience or gender are not the things it is limited to.

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5. Rational Behavior
People who invest in stocks are characterized as logical by the individuals who are efficient in
market information. These regular investors are just focused on the outcomes so that they can
maximize the profit by that. People, who stay abided by the same investing procedure on a day to
day basis, are compared to as the soldiers marching. In investment, being rational is the key and
the destination which creates the advantage of competitiveness.
6. Emotions and Investment
Investors always form their beliefs on the basis of their emotions involved in every bid. The
types of feelings like optimism, pessimism encourage or discourage them from time to time
during the investing process. Hence, emotions are clearly are vital in influencing the decisions of
the investors. EMH suggests that there is no influence of the emotions in the stock market and
the process of investing while behavior Finance emphasize on the emotions a lot and that they
are the back bone of the framework.
7. Efficient market hypothesis bubble
As far as the investors are investing in market very rationally, the bubbles that are created in
EMH cannot be understood. For example: the dot com bubble where internet based companies
enjoyed a very high stock price by just adding a .com to it in the end. These bubbles and t hese
arguments are in favor of dominating the Behavioral Finance over EMH.
8. A naïve hypothesis
EMH is not a very complicated theoretical framework as compared to the Behavioral Finance.
EMH is considered to be the naïve approach or a simple one. Being simple or naïve, it is very
popular with in investors from a long time as it gives out the positivity in investing decisions,
though the outcomes are serious. Behavioral Finance on the other hand is complicated and due to
this it is not accepted by the majority of the community (Kalra et al., 2014).
Implications of Behavioral Finance for Investment Managers

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While traditional theory states that the decisions made by the investors are mostly rational, the
modern theory says that this is not the case. Decisions are mostly inconsistent and they play a
very important role in influencing human mind by creating an illusion. The implications of
behavioral finance are informed by the two cognitive illusions: Heuristic Decision Process and
Prospect Theory.
 Heuristic Decision Process
When tools like algorithms, techniques and tricks are used for solving problems, and then
heuristic decision process takes place. When investors invest, their decision is not always
rational as it is very difficult to remove the emotions from in the process. The factors that are
included in Heuristic process are:
 Representativeness: The tendency to take decisions on the basis of the previous
experiences is known as stereotype. Tversky & Kahneman in 1982, defined
representativeness as: 1) When the parent population is equal to the event’s
characteristics and 2) Examines important features of procedure by which it yields.
 Overconfidence: It was studied by Guth, Dittrich and Maciejobsky in 2001, that only
two third of the participants are overconfident. Also it was observed that those who
lose their money in market are prone to becoming more confident. Confidence plays
vital role in gaining success. Although it is not the only source for gaining success, it
is encouraged by all and is considered to be a positive trait. Now when investors
become over confident, they tend to excessive training which is bad (Chaudhary,
2013).
 Anchoring: When people invest, they tend to think that the final result would depend
on the initial values of the trade in different situations but it might only be the partial
calculation and not the final one. Although later anchoring process was involved
where Kahneman and Tversky stated that different estimates lead to the initial values.
 Failure of Gamblers: When the probable results are being expected, lack of
understanding and incorrect estimation can be done sometimes. This lack of incorrect
decision making is known as Gamblers Failure.
 Bias Availability: It is like a cognitive bias which makes the human being to
overestimate the possible probabilities of the events with distinct happenings.

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Generally, investors give more weight on the mostly available information while they
make decisions (Jahanzeb et al., 2012).
 Herd Behavior: When the decision making is done by looking at other people’s
decision, it is known as the herd behavior. Whenever anyone new joins the market, he
being new would always look forward to other investor’s decision who is being
dealing with the market from a long time.
 Mental Accounting: Found by Richard Thaler, it is a concept in which the investors
frame the transaction the way they look at the utility they are expecting out of it. The
bias decision is when the investors value the money on the basis of the source from
where it is generated (Sharma, 2016).
 Conserve Nature: When any kind of change occurs, people tend to be slow toward
adapting those new changes. This is known as conservatism bias. If t he changes are
occurring on the larger basis, then people will adjust to it sooner and will react to that
sooner. They can also possibly overreact too in some circumstances.
 Effect of Disposition: An investor after investing the money does not want to sell the
share until it goes up on the price he put into it earlier. Even when the prices go down,
investor does not want to sell. This effect helps in realizing the small gains and small
losses that an investor might go through. It reflects in the average of the stocks
trading volume (Weber & Camerer, 1998).
 Loss Aversion: This theory is based on the idea that the loss that an investor carries is
greater than the gift of the gain of the same amount. If the investors are reluctant to
loss than they might invest even more to not be on the same position anymore. This
process explains averaging down tactics where investor is exposed to the stock that is
falling in order to regain what they have lost. This is known to be as escalation bias
(KONSTANTINIDIS, 2012).
 Regret Aversion: It rises when the investor wants to avoid the feeling of regret that he
gets from the loss of the amount in stocks when he made the poor investment
decision. When they regret the decision, they will be more prone to hold their shares
which are on the loss (Singh, 2012).
Behavioral Finance, Market Hypothesis and Investment Management and their Impacts on each other

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When an avid investor invests in the market, he should be able to invest his money in the right
way and at the right place. Investment management helps an investor to do that. Very often
emotions come in between the investment. It depends on the amount that is being invested and
the gains or the losses too (DUPERNEX, 2007). That is where behavioral finance comes into
picture. Investment Management is also related to the asset management as it helps in the
management of the infrastructures for operating the investments (Reyes, 2015). And efficient
market theory is also very important for the finance in the modern world. It can be applicable for
the capital markets (Degutis, 2014). Behavioral Finance basically refutes two implications of the
EMH.
 Majority of investors takes logical decisions on the basis of information available.
 The price of the market is always right (nyssa, 2010).
Efficient Hypothesis theory and behavioral finance both are important when it comes to
investment management as they both have different but helps in the same i.e. investment. Within
the last 50 years, EMH has been a subject of the academic research as it precedes fundamental
theory of movement in the assets. The basic definition of this is that the market always operated
efficiently and the stock prices are reflected in all the information. Now that everybody is keen to
know all that information responds to it immediately. The result of which is that the efficient
markets does not allow the investors to gain above average returns without taking any risks.
While EM theory prevails in the financial economy, the followers of the behavioral finance
believe that irrational and rational behavior or emotions influence the investor’s decision (Nath,
2015). Both these things does impact on the investment management as they both suggests
different theories. Proponents of both the theories think different and that changes the prospect of
investment management every now and then. Many behavioral finance concepts tend to refute
the efficient market hypothesis. But that does not mean that the efficiency should be discounted
on the whole. By understanding the weaknesses and the strengths of these theories can help the
investor to catch new information and take more informed and subtle decisions. The market
prices are high because millions of people thinking indifferently gets motivated by the emotions
they feel while investing, gaining or loosing. When all the members who are investing, think
alike, the estimate of the result or the prices is always inaccurate. In this situation, one can see

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the overflow of the information and motivation. It is the herd like behavior which creates one of
the two emotions: fear or greed. While greed can make the investors buy same group of stocks,
fear makes the investors pull their money out of the stock as they fear of losing it. Now
regardless of the one who promotes efficient market theory or not, most people agree to the fact
that creating the wisdom of crowds must be on the top priority of the avid investors, government,
policymakers and regulators (Lo, 2005).
Conclusion
This essay shows as to how behavioral finance and efficient market hypothesis helps in
investment management. When an investor invests in some stock, he goes through a lot of
emotional changes as it is said by behavioral finance. Yet efficient market hypothesis refutes this
theory of behavioral finance saying that emotions do not have any role in influencing the
decisions of the investors while investing. The difference between both these theories is also
discussed in this essay. There are some implications of behavioral finance for investment
managers. All are discussed in detail as all of them denote different theories and logic behind
investing. Finance recently seems to produce long term anomalies. The market anyway does not
suggest that market efficiency should be deserted. On the other hand behavioral finance brings
together the influences of human behavior in making investment decisions. It does not matter
how sophisticated the data is, the decisions has to be taken by the investor only (MITROI, 2014).

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References
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Sciences, 7(2).
Chaudhary, A.K., 2013. IMPACT OF BEHAVIORAL FINANCE IN INVESTMENT. Int. J. Mgmt Res. & Bus.
Strat, 2(2).
Degutis, A., 2014. THE EFFICIENT MARKET HYPOTHESIS: A CRITICAL. ISSN, 93(2).
DUPERNEX, S., 2007. WHY MIGHT SHARE PRICES FOLLOW A RANDOM WALK? Student Economic Review,
21.
Jahanzeb, A., Muneer, S. & Rehman, S., 2012. Implication of Behavioral Finance in investment decision-
making proces. Business and Management Review, 2(8).
Kalra, P., Gupta, E. & Bedi, P., 2014. Efficient Market Hypothesis V/S Behavioural Finance. IOSR Journal of
Business and Management, 16(4), pp.56 - 60.
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Behavioral-Finance.pdf [Accessed 2 February 2018].
Malkiel, B.G., 2003. The Ef cient Market Hypothesis and Its.Ž Journal of Economic Perspectives, 17(1),
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the-efficient-market-hypothesis-and-what-are-its-shortcomings-cm530860 [Accessed 2 February 2018].
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