Behavioural finance

While the early days of the efficient markets hypothesis involved a parade of confirmatory studies, the last 30 years has seen a steady flow of theory and evidence that brings all three forms of the hypothesis into question. Recent studies have found many anomalies, empirical studies that bring market efficiency into question absent a better explanation.

Due to the joint hypothesis problem, “absent a better explanation” is a important qualifier. The tests of market efficiency are effectively a joint test of two hypotheses: market hypotheses and the particular model of risk used in the analysis. This means that any “anomaly” could be either evidence of market inefficiency or an inappropriate risk-adjustment technique.

The result is that every discovery of an anomaly is followed by a debate as to whether it is truly an anomaly and whether there is a rational explanation for it. That said, some anomalies have been hard to explain away.

In the remainder of this book I examine a series of anomalies. Three relate to anomalies concerning individual stocks: lagged reactions to events and announcements, momentum, and value stock out-performance. Three concern aggregate stock market performance: the equity premium puzzle, bubbles and excessive volatility. Finally, I will close with an examination of trader performance.