Abstract
The efficient-market hypothesis (EMH) is one of the most important economic and financial hypotheses that have been tested over the past century. Due to many abnormal phenomena and conflicting evidence, otherwise known as anomalies against EMH, some academics have questioned whether EMH is valid, and pointed out that the financial literature has substantial evidence of anomalies, so that many theories have been developed to explain some anomalies. To address the issue, this paper reviews the theory and literature on market efficiency and market anomalies. We give a brief review on market efficiency and clearly define the concept of market efficiency and the EMH. We discuss some efforts that challenge the EMH. We review different market anomalies and different theories of Behavioral Finance that could be used to explain such market anomalies. This review is useful to academics for developing cutting-edge treatments of financial theory that EMH, anomalies, and Behavioral Finance underlie. The review is also beneficial to investors for making choices of investment products and strategies that suit their risk preferences and behavioral traits predicted from behavioral models. Finally, when EMH, anomalies and Behavioral Finance are used to explain the impacts of investor behavior on stock price movements, it is invaluable to policy makers, when reviewing their policies, to avoid excessive fluctuations in stock markets.
Highlights
The efficient-market hypothesis (EMH) is one of the most important economic and financial hypotheses that have been tested over the past century
The definition of market efficiency was first anticipated in a book written by Gibson (1889), entitled The Stock Markets of London, Paris and New York, in which he wrote that, when “shares become publicly known in an open market, the value which they acquire may be regarded as the judgment of the best intelligence concerning them”
Shefrin and Statman (1985) proposed that the Disposition Effect refers to two phenomena of the stock market: The first is that investors tend to have a strong psychology of holding loss-making stocks and are not willing to realize losses; and the second is that investors tend to avoid risks before profits, thereby willing to sell stocks in order to lock in profits
Summary
The efficient-market hypothesis (EMH) is one of the most important economic and financial hypotheses that have been tested over the past century. When not every investor in the stock market looks rational enough, the assumptions could be relaxed to include some “irrational” investors who could trade randomly and independently, resulting in offsetting the effects from each other so that there is no impact on asset prices (Fama 1965a). Fama and French (2008) pointed out that the financial literature is full of evidence of anomalies Another school (see, for example, Guo and Wong (2016) and the references therein for more information) believes that Behavioral Finance is not caused by “irrational” investors but is caused by the existence of many different types of investors in the market. When EMH, anomalies, and Behavioral Finance are used to explain the impacts of investor behavior on stock price movements, it is invaluable to policy makers in reviewing their policies to avoid excessive fluctuations in stock markets.
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