QUT EFB201 Essay: Efficient Market Hypothesis and Behavioural Finance

This essay critically evaluates the efficient market hypothesis (EMH) and behavioral finance, exploring arguments for and against each, and their implications for the future direction of an actively managed equity fund. It examines the work of Nobel laureates Eugene Fama, Robert Shiller, and Richard Thaler, discussing their contributions and contrasting viewpoints on market efficiency and investor behavior. The essay incorporates existing scholarly literature and real-world examples to support its arguments, analyzing how the EMH posits that market prices reflect all available information, while behavioral finance considers psychological influences on investor decisions. The essay then presents arguments for and against both concepts, considering factors such as information access, rational behavior, market anomalies, and volatility tests. Finally, the essay concludes on the validity of market efficiency and its implications for the equity fund, suggesting how these theories can be applied to predict future stock prices.

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Efficient Market Hypothesis and Behaviourial Finances
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Efficient Market Hypothesis
The efficient market hypothesis was widely accepted by the financial economist over the
past few decades ago. Such a wide acceptance was due to the fact that the stock prices were
typically reflected by the information that was provided by the securities market. The above idea
depends on the random walk theory which entails a price series in which there is often a change
in the price of stock randomly from the previous prices. According to this hypothesis, it prevents
the various investors from earning revenues which are above the average returns and this usually
occurs without agreeing to the above average risks (Degutis & Novickytė, 2014)
It, therefore, insists on an efficient financial market and this is in regards to the
communication, news, and information involved. An efficient financial market occurs when
there are numerous individual profit maximizers competing against each other and aims at
forecasting on the future market values of the securities.
Based on the work of Eugene Fama, he argued that the prices of the stock were a
reflection of the fundamentals of economics and that the prices changed randomly in the
financial markets.Fama, defined the efficient market hypothesis as a market which is competitive
and that the random feature of fluctuation is based on the price converges to the value which is
considered to be fundamental. He defended the Random walk because he considered it as a good
description of the fluctuations existing in the market for the stock and this is because the random
walk is a better estimation of the behavior of price. He also introduced the rationality concept
where he argued that an efficient market contains a huge number of rational profit maximizers
who are competing with the aim of forecasting the future market values.

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Robert Shiller however opposed the efficient market theory and this was specifically on
the random walk theory. He argued that the response of the stock market to new information was
never predictable.
Behavioural Finance
The behavioral finance involves a study of the behavior of the investor market and this is
usually based on the psychological principles in the process of making certain decisions. Such
decisions usually involve those providing insights on the reasons as to why certain individuals
purchase and sell stock. The concept of behavioral finance has been associated with the
behavioral cognitive which focuses on studying the economics of financial market and decision
making by human beings (De Bondt, Muradoglu, Shefrin & Staikouras, 2015). The primary goal
of the above concept is to focus on the interpretation of the investors and also their actions
towards the making of certain informed decisions on investment. Richard Thaler in his work
identified certain anomalies and the first one was in regards to the closed end funds. He defined
closed funds as the money which raises the investor’s capital and then it is later allocated to
stock or any other asset. Additionally, he suggested for a behavioral framework to comprehend
the closed end fund prices and this is because some of the prices would change based on an
investor’s sentiments.
Further, there is a certain reason which makes the behavioural finance to be considered as
an irrational behavior by the investors and such may include, the representativeness which entails
various individuals seeking to fit in certain new events (De Bondt et al., 2015).
In the real world, the above concepts are applied by most of the investors when making
certain fundamental investment decisions (Rad, 2016). For example, the efficient market
hypothesis has been sued by the investors to prevail over a particular stock market and this

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entails the use of information availed in such markets as an investment weapon. The behaviourial
finance on the other hand has been used by the investors to make certain rational decisions on
investment.
Arguments for Efficient Market Hypothesis and Behavioural Finance
There are various reason why the above mentioned concepts are selected while making
investment decisions by a variety of investors. Some of the arguments for efficient market
hypothesis and behavioural finance are as indicated below;
Availing and Providing Access to Information
According to Ţiţan (2015), the efficient market hypothesis, financial markets are typically
efficient in regards to information. It, therefore, implies that every particular investor will
generally have an access to information available and thus there will no exploitation on the
investment news. Additionally, the efficient market hypothesis provides generally some of the
best techniques of communicating various investment decisions to the individual investors. Some
of the methods used in communicating the information include the use of market analysts and
financial journals. The behavioural finance, on the other hand, plays a key role in ensuring that
the information which is inefficient is made efficient and this is usually in terms of the
availability and access to such an information by the individual investors.
Provision of Rational Behavior
The other reason for the argument for the efficient market hypothesis and behavioural
finance is because they enable rational behavior among the investors in the stock market. The
efficient market hypotheses argue that the investors in the stock market are usually rational in
their behavior and that their major concern is on profit maximization which is controlled by
certain rational expectations (Rad, 2016). The picture which is created by the efficient market

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hypothesis depicts the investors as machines which are well preserved and therefore they comply
with the existing rules on investment, which is usually rationality. The rational behavior is an
essential component of the behavioural finance and this is the reason it is argued for by the
various investors in the financial markets.
Arguments Against Efficient Market Hypothesis and Behavioural Finance
There have been a variety of arguments against the efficient market hypothesis which has
made it non-efficient for application in the world of economics. For example, there has been an
assumption that most investors are considered to be rational and hence they value their
investments in a rational manner (Arthur, 2018). However, the estimation of the net present
values for the future cash flows is not supported by such an assumption.
Further, it has been argued that there are certain anomalies which have been identified in
the various patterns of historical share prices. Some of the anomalies which have been as a result
of the efficient market hypothesis include mean reversion, January effect and the small firm
effect (Thaler, 2016). The above mentioned factors indicate that the efficient market hypothesis
does not lead to rational behavior among the investors and hence it has become the center of
criticism.
The other argument against the efficient market hypothesis has been based on the result
of volatility tests. According to the results of the test, it was found out that the movement of
stock prices is not a result of the rational expectations of the particular investors but it also
entails certain irrational elements. The irrational elements are displayed in the noise trading and
this, therefore, implies that the assertion made by the efficient market hypothesis is unrealistic.
The behavioural finance has been criticized for various reasons which makes it irrelevant
in the application to the investment decisions made in the financial markets (Tuyon & Ahmad,

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2016). For example, the behavioural finance has a limited critique of the economic theory and
this is illustrated by the concept remaining only in the individual level of analysis and this is
even though most of the investment decision are not made individually especially those relating
to risk and money.
The other reason for its limitation on criticizing the economic theory is based on the fact
that it does not give an explanation on the way various individual investors’ actions and
decisions result in certain aggregate outcomes. Such an argument has been attributed to the fact
that the behavioural finance does not take into account the interactive and social aspect of
various economic activities (Statman, 2014). The other argument against the behavioural finance
is based on its failure to identify the various findings relating to the allied social sciences. Such a
failure has become a huge rigid separation and boundary implementation and it is argued that it
limits the advancement of knowledge on various shared interest by a variety of scholars.
Conclusion
In summary, the efficient market hypothesis and behavioural finance will have an impact
in the future direction of the fund and this is because they will be used in forecasting the future
prices of the stock in the market. The long and short term moving averages will be used in the
prediction of the future prices of stocks. According to the efficient market hypothesis, once an
information will be made available in the financial markets, the prices of the stock will shift in
future. Further, the strategy of technical analysis of the behavioural analysis indicates that the
stock market prices will shift in trends based on the rational behavior of the investors.

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References
Arthur, W. B. (2018). Asset pricing under endogenous expectations in an artificial stock
market. In The economy as an evolving complex system II (pp. 31-60). CRC Press.
De Bondt, W. F., Muradoglu, Y. G., Shefrin, H., & Staikouras, S. K. (2015). Behavioral
finance: Quo vadis?.
Thaler, R. H. (2016). Behavioral economics: past, present, and future. American
Economic Review, 106(7), 1577-1600.
Degutis, A., & Novickytė, L. (2014). The efficient market hypothesis: a critical review of
literature and methodology.Ekonomika, 93(2).
Tuyon, J., & Ahmad, Z. (2016). Behavioural finance perspectives on Malaysian stock
market efficiency. Borsa Istanbul Review, 16(1), 43-61.
Statman, M. (2014). Behavioral finance: Finance with normal people. Borsa Istanbul
Review, 14(2), 65-73.
Rad, H. (2016). Pairs trading and market efficiency using an adaptive market hypothesis
framework: A pitch. Accounting and Management Information Systems, 15(1), 178-185.
Ţiţan, A. G. (2015). The Efficient Market Hypothesis: review of specialized literature and
empirical research. Procedia Economics and Finance, 32, 442-449.