Inefficient Markets & The New Finance
Short paper on the failures of the Efficient Market Hypothesis and several conclusion on how the field might change given research in new areas.
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Abstract (Via Stout @ UCLA)
By the early 1980s, the Efficient Capital Market Hypothesis (ECMH) had become one of the most widely-accepted and influential ideas in finance. More recently the idea of market efficiency has fallen into disrepute as a result of market events and growing empirical evidence of inefficiencies. This article argues that the weaknesses of efficient market theory are, and were, apparent from inspection of its initial premises, including the presumptions of homogeneous investor expectations, effective arbitrage, and investor rationality. By the same token, a wide range of phenomena inconsistent with the ECMH can be explained using market models that modify these three assumptions. To illustrate, this article explores three important strands of today’s finance literature: (1) work on asset pricing when investors have heterogeneous expectations;(2) scholarship on how and why arbitrage may move public information into prices more slowly and incompletely than earlier writings suggested; and (3) the exploding literature in behavioral finance. Taken together, these literatures provide the framework for building a new and more powerful working model of securities markets.
Excerpt (Via Stout @ UCLA)
Indeed, the framework for a new understanding may be in place. In particular, three strands of work in contemporary finance — the expanding literature on heterogeneous expectations asset pricing models, scholarly work on the limits of arbitrage, and the emerging field of behavioral finance — show great promise as new ways of thinking about markets. Taken separately, each of these three bodies of work can explain market puzzles that have proven intractable under orthodox efficient market theory. Taken together, they offer the intellectual framework for building a new theory that permits numerous testable predictions.
Click Here To Read Inefficient Markets & The New Finance (As PDF)
