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Market Efficiency, Long Term Returns and Behavioral Finance Structure

The main theme of the article is revolving around market efficiency and long term returns to investors.

Eugene F. Fama
University of Chicago - Finance

Problem:

Studies show that investors tend to focus on short term stock prices movement which is due to market efficiency. In a market efficiency situation, new about particular stock/industry places immediate effect on the stock prices and hence market is said to be efficient in response to the information received.

Research and Results:

Many stocks performance when observed over a longer period shows inadequate returns and market inefficiency however, the same stock when observed on day to day basis emerge as market efficient. The question is as to whether the market efficiency is good for investors or not? The answer is no for two major reasons. First, mostly over reaction to information is observed in the market and investors tend to complain that over-reaction is not good for assessment of stock price. But, if at one end, over reaction is being observed by some investors, there is a probability of under reactions to information by other investors. Second, if there are large long term return anomalies, then they cannot be attributed to chance.

There are two behavioral models of under and over reaction. The first is BSV Model that presents two judgement biases, representativeness bias and conservatism bias. The second model is DHS, in which there are both informed as well as uninformed customers. Informed investors show over confidence along with biased self-attribution. On the other hand, uninformed investors does not show any bias.

Conclusion:

Considering the arguments and studies made on the subject of market efficiency, we cannot abandon this concept as it is still applicable and there are chances that apart from over reactions to information resulting in stock price increase, there is a possibility of under reactions from investors.