Behavioral Finance Concept v. Efficient Market Hypothesis:

Behavioral Finance Concept v. Efficient Market Hypothesis:

For more than a century, the concept of efficient markets has been the subject of numerous academic researches and huge debates. An efficient market is described as a market with a large number of balanced profit maximizers that are actively competing against each other to forecast the future market values for individual securities. The efficient market is also defined as a market where current information is nearly freely available and accessible to all participants. Generally, in an efficient market, competition will make complete effects of new information on essential values to be reflected instantly in real prices (Singh, 2010). The efficient market hypothesis has developed to become a significant cornerstone of contemporary financial theory even though the market seems to be more modern and characterized by increased inefficiencies. As a result, the standard finance for rational analysis framework has been placed in an awkward position that has contributed to the emergence of behavioral finance theory that shakes the authority of efficient market hypothesis.

Behavioral Finance Theory:

Behavioral finance theory is a concept that emerged in the 1980s because of the shift towards including more behavioral science into finance. This concept has attracted numerous support across several economists because of some key areas in which the reality appears to be increasingly at odds with the efficient market hypothesis (Chuvakhin, n.d.). The concept of behavioral finance is a relatively new field that is geared towards combining cognitive psychological theory with traditional economics and finance. This is mainly for the purpose of providing explanations for the reasons people make irrational financial decisions (Phung, 2010). Behavioral finance theory is a rival account of capital markets due to theoretical and empirical restrictions or exceptions in efficient market hypothesis (Cunningham, 2002, p. 772).

Efficient Market Hypothesis:

Efficient market hypothesis can be described as the underlying concept that price reflects its essential value. It's a conventional framework in which the price of a security is equal to its fundamental value, which is the discount sum of future returns. The introduction of this term and financial concept is usually attributed to Eugene Fama, a concept that was further tested through various approaches in the 1960s. According to the founder of the concept, investors tend to be usually rational as markets precisely imitate all publicly known information. Consequently, the securities will usually be effectively priced since no amount of evaluation can contribute to out-performance. However, this concept has attracted numerous debates and criticisms as it's considered as one of the most egregious errors in the history of economic concepts (Wallace, 2010).

Difference between Behavioral Finance Concept and Efficient Market Hypothesis:

In the past few years, there have been numerous different arguments on behavioral finance concept and efficient market hypothesis, especially on the appropriate financial concept. Since 1990, the proponents of each of the two financial theories and concepts have developed and established various models that suit their position (Konte, 2008). The arguments have been raised because of the controversy surrounding efficient market hypothesis, which is a traditional framework and financial concept. Due to the controversies, academic professionals and economists have been forced to re-consider their thoughts regarding the composition of an efficient market and the efficiency of stock markets (Stangle, 2005, p. 124).

Throughout history, efficient market hypothesis has evolved as a vital concept in academic finance to be proved beyond doubt. On the contrary, behavioral finance has developed as a broader social science perspective because of its inclusion of psychology and sociology to an extent that its one of the most important research programs that significantly contradicts efficient markets theory. Consequently, there is a great difference between efficient market hypothesis and behavioral finance theory. Since the development of behavioral finance theory, the focus of academic discussion has moved from econometric evaluations of time series on earnings, dividends, and prices to establishing models of human psychology in relation to financial markets (Shiller, 2003, p. 90).

The main difference between these two concepts is that they are based on varying paradigms. The efficient market hypothesis paradigm based on individual's decision-making that is dependent on rational anticipations, discretionary assumption, and risk aversion ("Analysis of Behavioral Finance," n.d.). Fund managers and investors using the efficient market hypothesis to seize every arbitrage opportunities created by non-rational investors by betting against bubbles. For instance, in 2008, such investors bet against the bubble burst though they very few made any money from the ensuing market crash.

On the contrary, the paradigm of behavioral finance concept states that people's actual decision-making process is mainly based on human behaviors. Therefore, the theory does not consider people to be perfectly rational contributing to the fact that fund managers using the theory are not betting against bubbles. These fund managers and investors believe that investors make mistakes because of cognitive and emotional biases resulting in the under reaction or overreaction of equity prices to market news. Some of the common behavioral and emotional mistakes include loss aversion, overconfidence, and recency ("Behavioral Finance," 2010).

In conclusion, efficient market hypothesis is a traditional framework in finance that has several theoretical limitations and restrictions. Consequently, behavioral finance theory has emerged as an important concept with different paradigm shift from the conventional theory.

References:

"Analysis of Behavioral Finance Efficient Market Hypothesis for the Amendment and Innovation." (n.d.). Tastecaste.com. Retrieved July 25, 2012, from http://www.tastecate.com/freepages336095_Analysis-of-behavioral-finance-efficient-market-hypothesis-for-the-amendment-and-Innovation#