Efficient capital markets and the importance of behavioral finance

Extract

[...] The implications of efficient capital markets are related to technical and fundamental analysis. Technical analysis does not measure a security's intrinsic value and the frequency, in which statistical forecasting produces expectations for future activity, cannot disseminate the new available information. Technical trading cannot take advantage of this new information since when new information is public, price adjustment has already occurred and is already impounded in the current trading price. Fundamental analysis estimates a security's intrinsic value as to make superior market timing and take advantage of the new available information. [...]

[...] This paper investigates the importance of Behavioral Finance in efficient capital markets. The Efficient Market Hypothesis (EMH) and its division to three EMH sub-hypotheses (weak-form EMH, semistrong-form EMH and strong- form EMH) are presented in section 1. Also, the importance of informational efficiency is explained in relation to funds allocation to the highest- valued projects in order to mirror the fundamental value of the future cash flows. In section the importance of Behavioral Finance is analyzed in the context of Utility Function, Fusion Investing and Arbitrage Limitations. [...]

[...] To anticipate these cash flows, the market should reflect all new available information in current security prices and implicitly include the perceived risk of the security so that investors may use this information as the best forecasting tool of future value. As a response to the question whether security prices in efficient capital markets have indeed significant real-time implications for investors and portfolio managers, Behavioral Finance examines the psychological traits of investors, investigates the factors that contribute to capital market efficiency and tries to explain portfolio allocations that are inconsistent with the paradigm of the expected utility of wealth. [...]

[...] Therefore, investors cannot base their investment decisions on technical analysis, fundamental analysis or inside information, but on the other hand they should consistently expect profits that reflect an above average risk-rate of return The importance of Informational Efficiency Efficient capital markets allow to investors and companies to invest savings, borrow, and manage risk effectively. Capital markets bring together firms that seek to raise capital for future investments and investors, who seek for a profitable return on their investments. Investors seek for profit maximization through increased share values. [...]

[...] In Behavioral Finance, the weight of losses creates a greater feeling of distress compared to the enjoyment generated created by equivalent amount of gains Behavioral Finance and the Fusion Investing Many researchers assert that psychology and sociology assist considerably in understanding the efficiency of capital markets as well as explain market anomalies, bubbles, and crashes. The outperformance of specific stocks is subject to investors' irrational overconfidence in growth companies, but even more to the feeling of pride they derive from owning growth stocks. [...]