Market Efficiency and Behavioral Finance

Market Efficiency and Behavioral Finance

After completing this reading, you should be able to:

  1. Explain the three forms of Market Efficiency (EMH)
    • Understand the definition of efficient markets, and distinguish between the strong, semi-strong and weak versions of the EMH.
    • Identify empirical evidence for or against each form of EMH.
  1. Explain the main findings of behavioral finance:
    • Identify empirical examples of market anomalies that show results contrary to the EMH.
    • Understand how asset prices, especially in times of uncertainty and high volatility can deviate significantly from their fundamental values.

Definition of Efficient Markets

Market efficiency describes the extent to which available information is quickly reflected in the market price. In other words, an efficient market is one in which the price of every stock or security incorporates all the available information, and hence the price is the “true” investment value.

Market efficiency is highly important to active investment managers as they can exploit market inefficiencies and earn excess risk-adjusted returns.

Similarly, chief information officers (CIOs) of pension funds or endowments must seriously consider the efficiency of any market they invest in to determine how much to invest in active management over passive management.

Active management is one where the fund managers attempt to detect exploitable mispricing. On the other hand, passive management is where the fund manager simply aims to diversify across the whole market.

If a market is completely efficient, passive management is often the better choice due to lower costs, but active management tends to be the better choice in highly inefficient markets. Governments and market regulators are also concerned with market efficiency to the extent that an efficient market implies fair prices and optimal allocation of resources. In contrast, inefficient markets may ultimately lead to irrational resource allocation and below-average returns for unsophisticated investors.

Market Value and Intrinsic Value

The efficient market hypothesis is based on the prices of the stocks or securities depending on the amount of information available.

The market value of an asset is the price at which an asset can currently be bought or sold. The intrinsic value is the value that would be placed on it by investors if they had a complete understanding of the asset’s investment characteristics.

In an efficient market, market values should be an accurate reflection of perceived intrinsic value. In relatively inefficient markets, significant discrepancies may exist between market and intrinsic value to the point that investors in these markets may attempt to calculate independent estimates of intrinsic value to test if assets are being undervalued or overvalued.

Example: Market and Intrinsic Value

The per-share intrinsic value of Ford Motor Company (F) is believed to be $14.00. The current price of Ford stock in the market is $12.75.

What does this imply about the stock?


Due to the belief that Ford stock is worth $1.25/share more than it is currently selling for, then the market is undervaluing the stock price.

Factors that Affect a Market’s Efficiency

Most, if not all, markets can be thought of as existing on a spectrum between perfect efficiency and complete inefficiency. Several factors contribute to or impede the efficiency of a market. Some of these factors are listed below:

  1. Market Participants: In general, as the number and sophistication of participants within a market increase, the market becomes more efficient.
  1. Information Availability and Financial Disclosure: The more information market participants have, the more accurate the market’s estimates of intrinsic value, thus creating greater market efficiency. In highly efficient markets, information is provided to all market participants at the same time, and the advantage of insider trading is limited.
  1. Limits to Trading: Regulatory limits on activities such as short selling influence the actions of investors who may want to explore market inefficiencies and take advantage to make risk-free profits. The more stringent the restrictions, the more likely the market will be inefficient.
  1. Transaction and Other Costs: The efficiency of a market is defined by the ease and availability of information regarding security prices. If the cost of obtaining and analyzing extra information results in more profits, then investors may look to explore more of active management, thus affecting the overall efficiency of the market.

Forms of Efficient Market Hypothesis

Eugene Fama developed a framework of market efficiency that laid out three forms of efficiency. Each form is defined with respect to the available information that is reflected in the security prices. These forms are listed below:

Weak Form

  • All historical prices of securities have already been reflected in the market prices of securities.
  • Investors trading based on information from technical analysis (analysis of historical stock returns) should not earn abnormal returns.
  • According to research, at least weak form of efficiency is attained in developed markets.
  • Emerging/less developed markets may offer the opportunity to profit from technical analysis. Hence, these markets are not even weak-form efficient (known as inefficient).

Semi-Strong Form

  • Market prices reflect all the publicly available information including all historical price information.
  • Fundamental analysis does not result in higher earnings/returns to the investor.
  • Costs of obtaining additional information override the returns that the additional information might generate.
  • Market surprises do not lead to abnormal returns as markets are quick to adjust and resume normalcy.

Strong Form

  • Market prices reflect both private and public information.
  • Insider information does not lead to higher returns.
  • Most regulations would impose trade restrictions on senior company managers who have access to price-sensitive company information.
  • Research shows that markets are not generally strong form efficient as abnormal returns can be earned when private information is used.

Example: Forms of Efficient Market Hypothesis

In a given market, an ape throwing darts, an experienced technical analyst, skilled fundamental financial analyst, and an insider trader all earn the same long-run risk-adjusted returns.

Determine the form of market efficiency likely to apply in this market.


Since the insider trader cannot even earn higher risk-adjusted returns than the ape, the market must be strong-form efficient. If the trader could earn abnormal returns, the market would be semi-strong efficient. If both the financial analyst (utilizing public company information) and the insider trader could earn abnormal returns, then the market would be weak-form efficient.

Fundamental Analysis, Technical Analysis, and the Choice Between Active and Passive Portfolio Management

The table below shows how abnormal returns can be earned through various strategies and active management assuming different types of market efficiency.

$$ \begin{array}{c|c|c|c|c} \text{} & \begin{array}{c} \textbf{Technical} \\ \textbf{Analysis} \end{array} & \begin{array}{c} \textbf{Fundamental} \\ \textbf{Analysis} \end{array} & \begin{array}{c} \textbf{Insider} \\ \textbf{Trading} \end{array} & \begin{array}{c} \textbf{Active} \\ \textbf{Management} \end{array} \\ \hline \textbf{Weak} & \text{No} & \text{Yes} & \text{Yes} & \text{Yes} \\ \hline \begin{array}{c} \textbf{Semi-} \\ \textbf{Strong} \end{array} & \text{No} & \text{No} & \text{Yes} & \text{No} \\ \hline \textbf{Strong} & \text{No} & \text{No} & \text{No} & \text{No} \\ \end{array} $$

Since abnormal returns from the analysis of historical prices would be quickly arbitraged away in a weak-form efficient market, no technical analyst would be able to earn consistent abnormal returns. However, fundamental analysis and insider trading can still earn abnormal returns in a weak-form efficient market because public information and private information would not necessarily be fully reflected in market prices.

Similarly, active management that utilizes fundamental analysis could earn abnormal returns. Therefore, active management could consistently outperform passive management on a risk-adjusted basis – gross of fees – in a weak-form efficient market. If abnormal returns earned by active fundamental analysis exceed additional active management fees, active management could also earn abnormal returns net of fees.

Fundamental analysis and active management lose their ability to earn abnormal returns in a semi-strong efficient market due to prices fully reflecting public information. Despite active management’s inability to outperform passive management at the same risk level, active management may still be a rational investment option as a way for investors to manage certain risks and achieve financial goals.

In strong-form efficient markets, even insider trading cannot earn abnormal profits. Most markets are not strong-form efficient due to regulations against trading on non-public information.

Example: Forms of Market Efficiency

Which of the following statements is true regarding forms of market efficiency?

  1. In a weak-form efficient market, active management will outperform passive management net of fees.
  2. In a weak-form efficient market, fundamental analysis can earn abnormal returns, but technical analysis cannot.
  3. In a semi-strong form efficient market, no rational investor would invest in an actively managed fund.
  4. In a strong efficient market, there is need for insider trading regulations.
  5. None of the above.


The correct answer is B.

Since historical prices, but not all public information, are reflected in weak-form efficient market prices, a fundamental analyst could earn abnormal returns that a technical analyst could not.

Option A is incorrect: While active management should be able to outperform passive management gross of fees in a weak-form efficient market, its ability to outperform net of fees depends on how high abnormal returns are relative to additional management fees.

Option C is incorrect: An investor would not be capable of earning abnormal returns by investing in an actively managed fund in a semi-strong efficient market. However, the actively managed fund may still be a rational choice to achieve other financial goals, such as to keep the stream of cash flows of a retired investor constant.

Option D is incorrect: In a strong efficient market, there would be no need for insider trading laws and regulations since insider traders would not be able to outperform their non-insider trader counterparts.

Empirical Evidence for or against EMH

Difficulty with testing the Efficient Market Hypothesis

Empirical evidence suggests that it may be difficult to exploit temporary mispricing if appropriate allowances for the transaction costs and the cost of obtaining additional information are made.

Moreover, there is need to allow for an appropriate amount of risk since markets reward investors for taking risks. For instance, stocks with high betas should yield higher expected returns. Having said this, we can now test each form of market efficiency.

  1. Testing the Strong Form of EMH: This is difficult because it requires the investor or the researcher to have access to information that is not in the public domain in the first place. Studies also show that, even though directors have reach of this information, it is still not possible to outperform the market. This can be explained by the fact that certain regulations impose restrictions on senior management of any company on misusing their powers by for example, banning them from trading.
  2. Testing the Weak Form of EMH: If an investor uses historical prices to try and anticipate future prices (also called technical or chartist analysis), he/she will fail to identify the difference between the returns on securities and those from purely random stock selection after allowing for transaction costs, as studies have shown.
  3. Testing the Semi-Strong Form of EMH: The EMH is based on the principle that security prices reflect the information available. It does not however explain how the information affects the prices.

    Studies have shown that markets over\under react to events and/or new information, and take quite some time before reverting to normalcy. If this happens, the investors may take this opportunity to take advantage of the time before “healing” to make higher returns, and thus EMH would not hold. This is often called informational efficiency

    There also exists a school of thought postulating that; security prices are inherently volatile in nature. This therefore suggests that; fluctuation of the market value of securities could be just a result of the volatility and not necessarily a consequence of new information arriving from fundamental factors that could drive the prices up or down.

Market Anomalies

Market anomalies are exceptions to the notion of market efficiency. They may be present if a change in the price of an asset or security cannot directly be linked to current relevant information known in the market.

Market anomalies are only valid if they are consistent over long periods and not the result of data mining or examining data with the intent of developing a hypothesis. There is much debate if market anomalies truly exist after making appropriate adjustments for risk, transaction costs, sampling errors, and other factors.

Market anomalies can be categorized as time-series anomalies, cross-sectional anomalies, or other anomalies.

Time Series Anomalies

  • Calendar anomalies: Significant differences in returns exist on different days, months, or years. For example, the January effect, in which stocks tend to outperform in the month of January – part of which may be explainable by individual investors or fund managers selling off during the previous month.
  • Momentum/overreaction: Securities that have underperformed in the short/intermediate-term tend to outperform in subsequent periods.

Cross-Sectional Anomalies

  • Size effect: Small companies tend to outperform larger companies.
  • Value effect: Value stocks, which generally have below-average price-to-earnings and market-to-book ratios, and above-average dividend yields, have consistently outperformed growth stocks.

Other Anomalies

  • Closed-end fund discounts: Closed-end funds sometimes sell at a discount to their net asset value or the price that the fund’s holdings could theoretically be sold for if fully liquidated. Tax inefficiency and expectations of manager underperformance may partially explain this anomaly.
  • Earnings surprise: Stock prices have a tendency to underreact to new information, allowing for a momentum strategy (buying stocks with recent positive developments and selling stocks with recent negative developments) to be potentially profitable.
  • Initial public offerings (IPOs): Investors able to purchase a stock at its initial offering price earn excess returns. This is somewhat understandable as investment banks arranging the IPOs are often incentivized to set a low price.
  • Prior information: Some researchers have found that equity returns relate to prior information like interest rates, inflation rates, stock volatility, and dividend yields. However, this is not evidence of a market anomaly as abnormal returns cannot be earned using such information.

Example: Evidence against EMH

What characteristic used for stock screening is UNLIKELY to result in abnormal profits due to market anomalies?

  1. Market capitalization
  2. Earnings per share
  3. P/E ratio
  4. Interest Coverage Ratio
  5. None of the above


The correct answer is B.

Screening for stocks with larger market capitalizations and P/E ratios may arguably allow the investor to take advantage of abnormal returns based on cross-sectional anomalies. However, stocks with low/high earnings per share alone (without considering the price per share) have not been shown to generate abnormal returns.

Behavioral Finance

Behavioral finance examines investor behavior to understand how people make decisions, individually and collectively. It relates to the psychology that drives individuals’ choices when making investment decisions.

Common Findings of Behavioral Finance

Behavioral finance does not assume that investors always act rationally, but instead that people can be negatively affected by behavioral biases.

Market efficiency does not require all market participants to act rationally as long as the market acts rationally in aggregate. If the market can quickly adjust for irrationality, then behavioral finance does not necessarily contradict market efficiency. However, if the market allows its participants to earn abnormal returns from the irrationality of others, then the market cannot be efficient.

Empirical examples of market anomalies contrary to the EMH

Loss Aversion Bias

People tend to dislike losses more than they like comparable gains. For example, an individual would feel more pain losing $50 than gaining $50. This may help to explain under-reaction and overreaction market anomalies.

Herding Bias

Market participants tend to trade along with other investors, while potentially ignoring their own private information or analysis. This bias may also serve as a possible explanation for the under-reaction and overreaction to market anomalies.

Overconfidence Bias

People tend to overestimate their skills, knowledge, and ability to determine the intrinsic values of securities ultimately leading to mispricing accurately. This mispricing has been shown to mainly take place in higher-growth companies, whose prices react slowly to new information.

Additional evidence suggests that as people become more knowledgeable, the tendency to be overconfident increases. Despite individuals knowing that they are overconfident, hindsight bias and confirmation bias will lead them to still make the overestimated choices.

For example, individuals will tend to look for proof that justifies their point of view than the information that challenges their beliefs. This is known as confirmation bias.

Information Cascades

Similar to herding, information cascade is the transmission of information from those participants who act first and whose decisions influence the decisions of others. As investors base the decisions on the actions of other investors acting before them, stock returns may be serially correlated and lead to over-reaction anomalies. Research has shown information cascades to be greater for companies with poor information quality.

Other Biases

Other biases include representativeness (overweighting current situation in making decisions), mental accounting (separately accounting for different investments and individual security gains/losses), conservatism (maintaining prior views or forecasts despite new information), and narrow framing (viewing issues in isolation and responding based on how issues are posted).

Example: Behavioral Finance

A scientist runs a series of unweighted coin-flipping experiments with Bob, Bill, and Jane as test subjects. The scientist first invites Bob to wager $1 on the result of the coin flip, offering $3 if Bob is correct. Bob refuses.

Bill, however, is willing to pay $1 for the chance to win $1.50 ($0.50 profit) on correctly calling heads or tails because he recently lost $5 in the casino, and he must break even on gambles for the day.

Finally, the scientist does not ask Jane to wager money but instead offers her a choice of taking $0.50 or winning $1.00 if the next coin flip comes up heads. Jane takes the $0.50.

Which investor(s) has acted rationally showed mental accounting bias?

  1. Bob
  2. Bill
  3. Jane
  4. Jane and Bill
  5. None of the above


The correct answer is B.

Bill is likely doing mental accounting because his previous losses are sunk costs and shouldn’t motivate him to make bets with a negative expected value (a 50% chance to win $1.50 is only worth $0.75).

Option A is incorrect: Bob is likely affected by loss aversion as a 50% chance to win $3 is worth $1.50, but he is not willing to wager $1.

Option C is incorrect: Jane would have made a perfectly rational decision as she should be indifferent between the two options. By taking the sure $0.50, she may have acted out of risk aversion, which is often accounted for in standard financial models and not irrational behavior. As such she has not shown any bias.

Asset Prices in Times of Uncertainty and High Volatility

Stock prices can be excessively volatile; that is, the market value of the stocks whose volatility has been observed cannot be justified by the news arriving. This can be seen in the case of overreaction, which does not agree with the Efficient Marke Hypothesis (EMH). Therefore, stock prices are excessively high if the security prices are more volatile compared with the underlying fundamental values that are assumed to be driving them.

In 1981, Shiller developed a model with a rationally-varying forecast of future cash flows, interest rates, and risk. He considered the present value of dividends that were paid at some time and chose a terminal value. He was able to calculate the foresight price, which is the correct equity price if the market participants can predict future dividends correctly. The model states that, if the market participants are rational, we would expect no systematic errors. Moreover, if the market is efficient, the broad movements in the perfect foresight price should be correlated with the changes in the actual price as both react to the same information.

Therefore, Shiller found strong evidence against the EMH by the fact that the actual asset prices were more volatile than perfect foresight prices. However, the Shiller model has been met with shortcomings. For instance, the choice of the terminal value of the stock prices and the use of a constant discount rate.

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