The Emh, the Financial Crisis and the Behavioral Finance
The EMH, the Financial Crisis and the Behavioral Finance
1. Introduction The Efficient Market Hypothesis (EMH) that was first proposed by Fama (1965, 1970) is the cornerstone of the modern financial economic theory. The EMH argues that the market is efficient and asset price reflects all the relevant information concerned about its return. The genius insight provided by the EMH has changed the way we look at the financial crisis thoroughly. However, the confidence in the EMH is eroded by the recent financial crisis. People can not help to ask: if the market is efficient and the price of assets is always correct as suggested by the EMH, why there exists such a great bubble in the financial market during the recent financial crisis? Apart from that, the EMH has even been criticized as the culprit of the recent financial crisis. (See Nocera, 2009 and Fox, 2009) Actually after the EMH was proposed, many anomalies have been found in the financial market and financial economists have developed many theories in order to explaining these anomalies. Among these the most influential one is the so called behavioral finance, which argues that the complex human behavior plays an important part in determining asset prices. The rest of the essay is arranged as follows. Section 2 explains what the EMH implies and its limitations. Section 3 emphasizes on explaining the usefulness of the EMH in the context of the recent financial crisis. Section 4 focuses on interpreting the behavioral finance. Section 5 concludes the essay.
2. The implications of the EMH According to Ball (2009), the implication of the EMH can be summarized as follows. The implication of the EMH can be decomposed into two parts. The first insight of the EMH is related to the most profound insights of classical economics, that is, there is no excess profit in a complete market, which is due to the fierce competition in the market. If there exists excess profit in such a market, then the entry of new
1. Introduction The Efficient Market Hypothesis (EMH) that was first proposed by Fama (1965, 1970) is the cornerstone of the modern financial economic theory. The EMH argues that the market is efficient and asset price reflects all the relevant information concerned about its return. The genius insight provided by the EMH has changed the way we look at the financial crisis thoroughly. However, the confidence in the EMH is eroded by the recent financial crisis. People can not help to ask: if the market is efficient and the price of assets is always correct as suggested by the EMH, why there exists such a great bubble in the financial market during the recent financial crisis? Apart from that, the EMH has even been criticized as the culprit of the recent financial crisis. (See Nocera, 2009 and Fox, 2009) Actually after the EMH was proposed, many anomalies have been found in the financial market and financial economists have developed many theories in order to explaining these anomalies. Among these the most influential one is the so called behavioral finance, which argues that the complex human behavior plays an important part in determining asset prices. The rest of the essay is arranged as follows. Section 2 explains what the EMH implies and its limitations. Section 3 emphasizes on explaining the usefulness of the EMH in the context of the recent financial crisis. Section 4 focuses on interpreting the behavioral finance. Section 5 concludes the essay.
2. The implications of the EMH According to Ball (2009), the implication of the EMH can be summarized as follows. The implication of the EMH can be decomposed into two parts. The first insight of the EMH is related to the most profound insights of classical economics, that is, there is no excess profit in a complete market, which is due to the fierce competition in the market. If there exists excess profit in such a market, then the entry of new