Behavioural Finance and the EMH
The behavioural finance literature argues that the anomalies discussed earlier are consistent with irrationalities observed in individuals when making complex decisions that is

Investors dont always process info correctly and therefore infer incorrect probability distributions about future rates of return
Even if they have correct probability distributions, they often make inconsistent or systematically suboptimal decision.

Irrationalities fall into two broad categories: first, that investors do not always process info correctly and therefore infer incorrect probability distributions about future rates of return,behavioural biases or the potential for investors to make decisions irrationally based on the information set they have access to even if this information is processed perfectly and limits to arbitrage or ability to profit from any mispricing

Information processing- Can lead investors to misestimate true probabilities of possible events or associated rates of return

Forecasting errors-People give too much weight to recent experience compared to prior beliefs when making forecasts and tend to make forecasts that are too extreme given the uncertainty inherent in their information.
Overconfidence- people tend to overestimate the precision of their beliefs or forecasts and tend to overestimate their abilities
Conservatism bias (or under-reaction)- Investors are too slow in updating their beliefs in response to new evidence which means they initially underreact to news about a firm so prices will fully reflect new information only gradually. Such a bias would give rise to momentum in stock market returns.
Representativeness- people commonly do not take into account the size of a sample acting as if a small sample is just as representative of a population as a large one

Behavioural Biases- Even if information processing were perfect, many studies conclude that individuals would tend to make less than fully rational decisions using that info. These biases would affect how investors frame questions of risk versus return and therefore make risk-return trade-offs.

Framing- The way investment choices are framed can significantly impact how investors choose between them e.g. individuals may act risk averse (loving) if a gamble is posed in terms of gains (losses)
Mental Accounting- Where investors segregate certain decisions e.g. they may take risks with their gains that they would not take with their principal
Regret Avoidance- If outcome is bad, individuals have more regret when the decision was more unconventional
Prospect Theory- This suggests unlike conventional finance theory which argues utility depends on the level of an investors' wealth, it actually depends on changes in wealth from current levels.

Limits to Arbitrage- In practice, several factors limit the ability to profit from mispricing

Fundamental Risk- It's risky to invest in stocks that are underpriced; what if the underpricing gets worse?
Implementation Costs- Trading is not costless, transaction costs may make mispricing not worth exploiting e.g. when exploiting overpricing and short selling a security will entail costs, also, short sellers may have to return the borrowed security on little notice, rendering the horizon of the short sale uncertain.
Model Risk- If valuation model is faulty, the stock might not really be mispriced.

	Created by Nafisa Zahra over 10 years ago

University Investments (Eff. market hypoth., behavioural finance & technical analysi) Note on Untitled, created by Nafisa Zahra on 02/10/2013.