Efficient Market Hypothesis v’s Behavioural Finance An efficient market is one in which share prices quickly and fully reflect all available information, where investors are rational, and there are no frictions. Investors determine stock prices on the basis of expected cash flows to be received from a stock and the risk involved.
Rational investors should use all the information they have available or can reasonably obtain, including both known information and beliefs about the future. In an efficient market there is “no free lunch”: no investment strategy can earn excess risk-adjusted average returns, or average returns greater than are warranted for its risk (Barberis, 2003). Market efficiency is assessed by determining how well information is reflected in stock prices.
In a perfectly efficient market, security prices quickly reflect all available information and investors are not able to use available information to earn excess returns as it is already incorporated in prices. The hypothesis that says security prices reflect all available information thus making it difficult for investors to make abnormal returns is the efficient market hypothesis (EMH).
The foundations of EMH rest on three basic arguments 1) investors are assumed to be rational and hence they value securities rationally, 2) to the extent that some investors are not rational, their trades are random and hence cancel each other out ultimately having no effect on prices, and 3) if investors are irrational, they will be met in the market by rational arbitragers who will eliminate any influence they have on the market (Lawrence, McCabe ; Prakash, 2007).