MARKET EFFICIENCY MODELS AND TESTS

Market Efficiency Models and Tests



Market Efficiency Models and Tests

Introduction

Behavioral finance studies how investors actually behave when making financial decisions. Therein lies the fundamental difference between neo-classical finance and behavioral finance. Specifically, it is the study of how psychology affects individual financial decision making and the impact this has on the financial markets. A more appropriate designation for BF might be called “cognitive finance”. Some advocates of BF take an informal approach, suggesting that the paradigm can be distilled down to a simple mantra of “embracing the irrationality of investors”. BF is an attempt to augment the normative explanatory power of traditional finance by providing it with more realistic psychological foundations.

Market Efficiency Models and Tests

There is a growing body of empirical research that indicates financial markets often fail to behave as they should if trading were truly dominated by the fully rational investor that is assumed in the classical theory. Despite empirical evidence that the stock market is semi-strong efficient, there are many studies documenting long-term historical anomalies in the stock market that would seem to contradict the validity of the EMH. While the existence of these market anomalies is generally well accepted, the question of whether or not investors can exploit them in systematic fashion to earn superior returns in the future is less clear. “A market is efficient with respect to a particular set of information if it is impossible to make abnormal profits (other than by chance) by using this set of information to formulate buying and selling decisions” (Sharpe 1984). The only rational investment strategy consistent with the concept of efficient markets is indexing using Electronic Traded Funds (ETFs). The conundrum is, however, if everyone indexes, the markets will no longer be efficient

BF still remains at the fringes of modern financial theory, perhaps because there is still no behavioral equivalent of the CAPM, a technique rapidly being replaced in academia, but still widely employed in practice. BF looks at investor preference functions in an intuitive fashion as opposed classical investment theory's mathematical closed-form model solutions. The goal of BF is to make predictions that are more consistent with the empirically observed outcomes. BF is an attempt to explain what causes some of the stock market anomalies that have been observed and reported in the finance literature, such as the calendar effect, weather, the weekend effect, small firm effect, closed end mutual fund paradox, and momentum strategy.

At the root of the pedagogical differences is the notion that BF rejects the EMH as envisioned by Fama, which for decades has been the standard finance valuation paradigm, both in assumptions underlying the model and in the practical applications. Eugene Fama (1970) framed the definition of EMH and identified the three variants of it: (1) superior or private information (strong-form EMH); (2) superior cognitive processing of information (semi-strong EMH); and (3) the ability to interpret charts and patterns to select investments (weak-form EMH). Fama (1991) stated “…market efficiency per se is not ...