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Homo Oeconomicus 24(1): 8193 (2007)
Market Efficiency cum Anomalies,
or Behavioral Finance?
George M. Frankfurter
Lloyd F. Collette professor Emeritus at Louisiana State University, Baton Rouge, USA
(eMail: pitypalaty@cox.net)
Abstract The efcient markets hypothesis of Fama and the capital asset pricing
model of Sharpe constitute the paradigm of what is often called modern fnance.
Although early, joint tests of both the hypothesis and the model showed the signs
of existence, serious doubts started to surface with the large-scale discovery of
efects, for which neither the former nor the latter could account. For a long time
such efects were noted but largely dismissed as anomalies; deviations or depar-
tures from the norm. It was not until prospect theory of Kahneman and Tversky
found its way to the fnancial economics literature that an alternative logic of in-
vestors behavior has been seriously contemplated and tested. This literature is re-
ferred to by its practitioners as behavioral fnance. Yet, the afcionados of modern
fnance call the empirical fndings of behavioral fnance as another set of anoma-
lies. This paper is about the diferences between modern and behavioral fnance,
and how the proponents of the former try to perpetuate their theory by referring to
the latter as anomalies.
Keywords market efciency, behavioural fnance, fnancial economics paradigm, modern
fnance
We have frst raised a dust then complain we cannot see.
Bishop Bradley, Principles of Human Knowledge.
1. Introduction
Famas Efcient Capital Markets: A Review of Theory and Empirical
Work saw the light of publication (Fama, 1970) in 1970. The paper re-
defned his earlier allusion to capital markets efciency (Fama, 1965) and
simply argued that in an efcient market prices refect all what there is to
know about a capital asset. Later, Famas efcient market hypothesis
[EMH, subsequently] was endowed with three distinct forms of infor-
2007 Accedo Verlagsgesellschaft, Mnchen.
ISBN 3-89265-064-0 ISSN 0943-0180
82 Homo Oeconomicus 24(1)
mational efciency, namely, the weak, the semi-strong, and the strong
forms.
1
Although the exact origins of these three forms are not explicitly
known, or traceable, it is generally held that:
the weak form implies a random walk of some form (part of Famas
1965 defnition of efciency), and that one cannot take advantage of the
knowledge of historical price movements,
the semi-strong form implies that prices at any given time incorporate
all publicly available information, and
the strong form implies that prices at any given time incorporate all in-
formation, whether public or private.
The EMH revolutionized beliefs about the pricing and the operation of
capital markets, because it was in line with an ideology that markets,
whether capital or otherwise, know best. Accordingly, one must conclude
that as a social policy, the best government can do is not to interfere with
such operation because it would make something which is efcient (good)
inefcient (the opposite of good), to be slighted and avoided.
Sharpe (1964), Lintner (1965), and Black (1972) conjured up a statisti-
cally testable model that described the pricing mechanism of capital assets.
It should be remembered, thought, that both the EMH of Fama and the
capital asset pricing model [CAPM, subsequently] of Sharpe described the
operation and the characteristics of capital markets. That is, markets not
just for stocks but all capital assets. Regardless, all subsequent tests of both
the model and the hypothesis were done on a universe, some times even
limited universe, of common stocks.
In this paper I am discussing how doubts about both the model and the
hypothesis surfaced, how the believers in the model have been trying to
fght of eforts to replace them, and what language is being used to ac-
complish the latter task.
I will also ofer my beliefs regarding the emergence of a possible alter-
native paradigm and its future.
2. Here come the efets
The EMH and CAPM were internally consistent and connected in the
sense that the latter provided a means for testing the former. This syn-
thesis opened a door for empirical validation of both the hypothesis and

1
There are also two other dimensions of efciency, namely, allocational efciency and
liquidity. In the interest of the discussion here these other forms can be disregarded.
G.M Frankfurter: Market Efciency cum Anomolies 83
the pricing model. Through this door, or rather foodgate, thousands of
research papers marched to accept or reject the validity of either or both
the hypothesis and the model. A very large number of these empirical
studies found that the theory couldnt be rejected, based on the data that
were available at the time.
2
Yet, after a while numerous studies have found results that showed the
existence of efects that the CAPM could not explain or were consistent
with the EMH (that all relevant information is refected in the price). The
list of the efects is rather large, but some at least must be mentioned here.
Banz (1981) and Rienganum (1981) found evidence that the CAPM
understates cross-sectional average returns of NYSE and AMEX listed
frms with low market values of equity and overstates those of frms with
high market values of equity. This well-known phenomenon is now gen-
erally referred to in the literature as the Small Firm Efect (SFE).
Lamoureux and Sanger (1989) fnd the SFE in NASDAQ traded frms and
conclude that the SFE cannot be attributed to market structure diferences
between the NYSE/AMEX and the NASDAQ. Symmetrically, they con-
clude that these markets are not diferent one from the other. After the
2000 melt-down of the dotcoms the Lamoureux and Sanger (ibid.) fnd-
ings were seriously questioned.
Nevertheless, evidence contrary to the SFE also exists. Keim (1983) and
Brown, Kleidon and Marsh (1983) fnd instability and reversals in the frm
size anomaly for NYSE/AMEX listed frms. Their results indicate that
factors other than the relation between a stock's return and overall market
returns need to be incorporated in modeling frm's expected returns.
Other empirical evidence supports the view that the relation between risk
and stock returns is captured by some combination of frm specifc and
market specifc information.
Basu (1983) fnds E/P (earning/price) and frm size to be constituents of
average returns for NYSE/AMEX listed frms. Nonetheless, Basu also fnds
beta, as extracted from the CAPM, to be positively related to returns,
indicating that an overall market factor is a component of expected re-
turns. In addition to frm size and beta, Bhandari (1988) documents that
leverage, as measured by the total debt-to-equity ratio, is instrumental in
explaining expected stock returns of NYSE/AMEX frms. Chan and Chen
(1991) attribute the SFE to the fact that portfolios of small NYSE frms
contain a large proportion of marginal, fnancially distressed frms. They
argue that high leverage and reduced dividends explain abnormal returns
3



2
For an extensive list of references of this literature please see Frankfurter (2001).
3
The term abnormal return comes from the voluminous literature of event studies. De
facto, abnormal returns are nothing else but the arbitrary compilation of error terms from a
84 Homo Oeconomicus 24(1)
associated with portfolios of small frms.
Fama and French (1992) analyze both NYSE/AMEX and NASDAQ
traded frms and fnd that market capitalization and the ratio of the book
value of equity to the market value of equity better explain cross-sectional
average stock returns than beta, leverage and E/P. They suggest that frm
size and the book-to-market equity ratio are useful for extracting market
information about risk and expected returns, because they are better
proxies of risk. Basu (1983) and Bhandari (1988) also discredit the impor-
tance of beta in the explanation of market returns, just as Fama and
French (1992) do later.
Amihud and Mendelson (1986) develop and empirically verify a
liquidity hypothesis under which asset returns are positively related to the
relative bid-ask spread, which in turn are negatively related to investor
liquidity needs. Furthermore, they fnd the SFE to be a consequence of the
spread efect, with frm size functioning as a proxy for liquidity. The sig-
nifcance of the bid-ask spread and the inconsequence of size reported by
Amihud and Mendelson (1989) gives rise to the postulate that excess re-
turns of small frms is an illiquidity premium caused by either the lack of
investors' interest and/or paucity of publicly available information.
Merton (1987) develops a multi-period CAPM that rests upon the as-
sumption that market participants require a premium for investing in
frms for which little public information is available. This notion, later, is
parlayed into the neglect efect, whereas frms returns which are not fol-
lowed at all, or by a small number of analysts are inferior of those frms
that are followed by a large number of analysts
Investor interest and publicly available information may also vary ac-
cording to the market in which a frm's stock is traded. Studies of the early
1990s document signifcantly higher returns for NYSE/AMEX listed frms
than NASDAQ frms (in contrast to Lamoureux and Sanger, 1989, who
fnd no diference between the two markets). One must not wonder, based
on 1999s record braking performance of the NASDAQ how well this, as
well as all other, empiricism stands up to time. This is so, because the
NASDAQ practically crashed and burned in 2000 barely recovering since.
Reinganum (1991) fnds the NASDAQ to be more liquid than the
NYSE for small frms. Reinganum ascribes the higher return on NYSE
small frms to a liquidity premium. Loughran (1993) attributes the difer-
ence between frm's returns on the NYSE and the NASDAQ to the poor
performance of recent Initial Public Oferings [IPOs, subsequently] on the
NASDAQ, while Fama, French, Booth and Sinquefeld (1993) attribute the
diference between NYSE/AMEX and NASDAQ traded stocks to higher

simple linear regression often called the market model.
G.M Frankfurter: Market Efciency cum Anomolies 85
fnancial distress for NYSE frms. Overall, these results indicate that there
might be an exchange afect that has to be controlled when studying frm
specifc returns.
The fndings of these efects, as well as other, more exotic efects, such
as the end-of-the-month, year, Yom Kippur, neglected stocks, etc.,
efects that showed the lack of validity of Sharpes CAPM were christened
anomalies, a diminutive term that implied a tolerable aberration from a
ruling belief system. And because according to Fama (1998) the CAPM
and the EMH are inseparably linked, the existence of these anomalies, and
others I have not mentioned, are not sufcient to either refute the hy-
pothesis or the model.
3. or behavioral fnance
Two wrongs dont make one right, but they make a good excuse.
Thomas Szasz
Serious questioning of modern fnance as a paradigm started with the im-
portation of prospect theory of Kahneman and Tversky (1979) and
Tversky and Kahneman (1990) into studies of asset pricing. Prospect the-
ory is just one alternative to the expected utility maxim (EUM, subse-
quently), based on the rationale and untold numbers of experimental
psychology studies, that the Von Neuman and Morgenstern (1967) [VM,
subsequently] axioms upon which EUM builds do not hold. I am espe-
cially nonplussed for two reasons:
Why only prospect theory, and not other alternative theories of deci-
sion making? and
How fnancial economics was made immune to the rich literature of
other alternatives?
Being conspiracy theorists I may be able to answer the second question.
An elite who professionally benefted from a positivist way of thinking
kept out the literature critical to the EUM, starting with Allias Paradox
(1952), continuing with Rubinsteins (1988) Similarity, and half a dozen
other alternative paradigms, not germane to the current issue. I must ad-
mit, however, that I have no answer to the frst question.
3.1 Overreaction
The precursor to the over/under reaction hypothesis of DeBondt and
Thaler (1985, 1987) is Basu (1978) who reports superior returns of low P/E
stocks and inferior returns of high P/E stocks. Basu interprets this fnding
as inappropriate response to information inconsistent with the EMH that
86 Homo Oeconomicus 24(1)
is later corrected.
Dreman (1979) builds his argument on psychological factors. Accord-
ingly, he hypothesizes that investors react to events in a fashion that con-
sistently overvalue the prospects of best investments and undervalue
those they consider the worst. Earlier others, (Hickman; 1958, and
Atkinson; 1967) fnd similar reactions to disappointing reports.
But the real boost to the overreaction hypothesis comes from DeBondt
and Thaler (1985, 1987), as mentioned earlier. Dreman and Berry (1995)
summarize the hypothesis six predictions:
For long periods best stocks underperform while worst stocks out-
perform the market.
Positive surprises boost worst stock prices signifcantly more than they
do the same for best stocks.
Negative surprises depress best stock prices much more than they do
for worst stocks.
There are two distinct categories of surprises: event triggers (positive
surprises on worst stocks, and negative surprises on best), and re-
inforcing events (negative surprises on worst stocks and positive sur-
prises on best). Event-triggers result in much larger price movements
than do reinforcing events.
The diferences will be signifcant only in the extreme quintiles, with a
minimal impact on the 60% of stocks in the middle.
Overreaction occurs before the announcement of earnings or other sur-
prises. A correction of the previous overreaction occurs after the sur-
prise. Best stocks move lower relative to the market, while worst
stocks move higher, for a relatively long time following a surprise.
Dreman and Berry (1995) claim that all six predictions of overreaction
show statistical signifcance.
Other overreaction evidence is found in Fama and French (1992),
Lakonishok, Shleifer and Vishny (1994), and Loughran and Ritter (1996).
Much research of overreaction is in the IPOs literature of which I care to
mention here Loughran and Ritter (1995). In a nutshell, several studies
showed the long term performance of IPOs is below what the market ex-
pects it to be at the time of the initial ofering. Is it possible that the market
is a slow or disadvantaged learner?
3.2 Underreaction
A number of event studies (yet again!) show evidence of underreaction,
just to balance the inefciency of the market. Obviously, underreaction is
the instance where the market, supposedly informationally efcient, does
G.M Frankfurter: Market Efciency cum Anomolies 87
not react to information in time, or does react in an insufcient manner:
too little, too late. Bernard and Thomas (1990) and Abarbanell and
Bernard (1992) show that fnancial analysts underreact to earnings an-
nouncements, either over or under estimating quarterly earnings after
positive (negative) surprises. Michaely, Thaler and Womack (1995), fnd
price responses to dividend cuts and/or initiations to continue for an ex-
cessively and irrationally long time. Ikenberry, Lakonishok and Vermaelen
(1995) contend that investors underreact to frms share repurchases.
3.3 Contrarians at the gate
All the empirical evidence of the behavioral fnance literature gave rise to
an investment strategy that systematically exploits the fact that the market
is not as efcient as the high priest and their sycophants, toadies and
minions of the EMH want everyone to believe. Perhaps the best-qualifed
spokesperson of the contrarians is David Dreman who not only wrote two
books on the subject (1979, 1998), but at one time also actively managed
$8 billion in assets. Dreman and others believe that they can systematically
outperform the market by taking advantage of psychological factors that
many of the studies I mentioned so far show to exist, and because of which
the market cannot be efcient. For the contrarians whether the market is
efcient or not is an important, yet only a secondary issue. What counts is
beating the market, consistently, a strategy tantamount to not to invest in
the market as a whole, or mimic a popular index.
3.4 Summary
The trouble with behavioral fnance at its present stage of existence, and as
a viable alternative to the EMH, is threefold.
It does not amount to a comprehensive methodology, a clear combina-
tion of ontology (what is to be known), and epistemology (how it is to
be known).
Its empirical evidence is almost exclusively event-studies, which I criti-
cized elsewhere (Frankfurter and McGoun, 1995), and about which
perhaps the words of the greatest living American philosopher, Yogi
Berra sound true: I believe it when I believe it.
Its structure, with the exception of some basic assumptions regarding
investors behavior, is the same as the EMH and its aim is the exclusive
discreditation of the EMH. This gives the home court advantage to the
EMH, because behavioral fnances fndings can be and often are re-
buked by the proponents of the EMH on technical grounds.
88 Homo Oeconomicus 24(1)
Perhaps, one of these days researchers in fnance will wake up and
realize that whether markets are efcient or not is not the issue. The issue
is to learn more about the decision processes of real investors and fnd a
way to categorize such behavior so later a comprehensive theory could be
developed on this foundation.
4. Why then anomolies?
Out of timber so crooked as that from which man is made,
nothing entirely straight can be carved.
Immanuel Kant
First, Ball (1996), then Fama (1998) attack behavioral fnance, the former
with vehemence, and the latter with cunning. Ball (1996) argues that one
has to stick with the EMH because (1) we dont have anything better, (2) it
sufced in the past, and (3) it is now a matter of belief. Certainly, alterna-
tives to the EMH are few. Ball can think of only one, which he calls be-
havioral fnance, (ibid., p. 10) referring, principally, to the works of
DeBondt and Thaler (1985, 1987). Ball (ibid., pp. 10-11) dismisses this
behavioral fnance on the grounds that:
Investors myopia implied by the DeBondt and Thaler work would be
grossly inconsistent with the notion of competitive markets. (How
could one possibly doubt that they are competitive?)
Behavioral fnance is also replete with its own anomalies. (Let he who is
without sin cast the frst stone.)
The claim that efcient marketists suppressed evidence contrary to
their beliefs is at variance with Balls own views and with the fact that in
a co-authored work with Brown (Ball and Brown, 1968) they discov-
ered post-earnings-announcement drift in prices. (We have been
doing business in the same location for over 40 years. Doesnt conti-
nuity count for something?) (See, Frankfurter and McGoun, 1999).
There is no question that the Balls second point is well taken. There is
no theoretical model that at one point or another in its life-cycle would not
have been burdened with exceptions to its rules, or aberrations from its
dictum. The frst point, however, is wishful thinking, the product of an
ideology to which Ball and the Chicago/Rochester School subscribe, and
the last point is meaningless.
Famas (1998) dismissal of behavioral fnance is far more cleft and
crafty. Fama aims with the careful screening of 20 or so papers, mostly
from the domain of post-event studies, frst, to discredit empirical evi-
G.M Frankfurter: Market Efciency cum Anomolies 89
dence. Then, second, that random and conficting evidence is proof of the
existence of the EMH. Thirdly, that event studies are not merely a method,
but a methodology. And lastly, making behavioral fnance synonymous
with anomalies.
Perhaps this is the most important objective of Fama, because as long as
everything else is just an anomaly the EMH is, practically, irreplaceable.
4

In essence, when one lumps behavioral fnance together with the efects
literature and one calls it anomalies, one creates an unshakable and im-
penetrable dogma.
5. A paradigm shift?
One can live in the shadow of an idea without grasping Elizabeth Bowen
Is it opportune then to talk about a drastic change of course, what is usually
called in the natural sciences, a paradigm shift? An appropriate defnition of
paradigm shift is by Colin Bruce.
Science is generally supposed to proceed in patient incremental steps. But
just a few times in the history of science an experiment has produced a result so
paradoxical, so difcult to explain in terms of the expected order, that the whole
framework of current assumptions about the world has to be abandoned in fa-
vor of a new more subtle picture (Bruce 1998).
Accepting Bruces defnition, it is clear that behavioral fnance is no
paradigm yet, much less is it a shift. This is so, because when and if one
peels away the surface claim of behavioral it is no more than traditional
(modern) fnance with diferent assumptions. Although its assumptions
more realistically describe individual behavior and investment psychology
than modern fnance this does not make behavioral fnance a paradigm.
The objectives, methods and data of research are exactly the same as in
modern fnance.
Behavioral fnance then is neither a new paradigm, nor is it a diferent
methodology. Yet, it is call for a cause clbre. It has the potential to be-
come one, if instead of attacking it researchers would be encouraged to de-
velop it further, quite possibly importing the methods and procedures
used in related social sciences.
There is a lot to learn from psychology, sociology, and anthropology.
This learning cannot and will not take place if researchers are not allowed
to publish their work, or being warned of because of their way of inquiry.

4
Here I should remind the reader that Fama and French (1992) conclude that has no
predictive power, the ultimate failure of a positive model. Yet Fama (1998) makes the point
that the CAPM and the EMH are inseparably intertwined.
90 Homo Oeconomicus 24(1)
It would be no ones loss and perhaps everybodys beneft if the chance
were given to behavioral fnance to be fully developed. The same elite that
are trying hard to forestall such development should be the frst one to
recognize this simple truth, if for nothing else but in the name of academic
honesty.
There are a few positive developments, nevertheless, that may ring in a
promising future for behavioral fnance. First, there is the fact that the
Nobel Prize for economics in 2001 and 2002 went mostly to scholars who
were instrumental in creating behavioral economics. As a consequence,
behavioral economics, after 20 odd years being in the making, gained le-
gitimacy as a subfeld. Because fnancial economics is closely tied to trends
in economics, it is reasonable to surmise that behavioral fnance will gain
legitimacy, as well.
A related supporting signal is the existence of a journal that carries the
name: The Journal of Behavioral Finance. This is the journal that formerly
was known as The Journal of Psychology and Financial Markets. The name
change may look mere symbolism, yet there is much more to it than just a
new name for an old icon. The fact that the journal is named after a pos-
sible subfeld of fnance is an invitation for research and work that previ-
ously couldnt fnd a place in the mainstream journals of fnance. That is,
work that otherwise could survive the scrutiny of academic standards
could not be published, because the referees and the political inclination of
the journals were not in tune with the fndings.
In the words of Ludwig Wittgenstein Knowledge is in the end based on
acknowledgment. Accordingly, research is done frst and foremost to be
recognized. To be recognized the researcher needs an outlet. This new
journal can very well become such an outlet, inspiring more work in the
subfeld.
And lest not forget that it is also tenure and promotion that goes to-
gether with recognition. Faculty, especially, young and more productive
faculty will not start work where the possibility of publication, even as just
a promise, does not exist.
Finally, being the eternal optimist by nature, I most sincerely believe
that a reality retardant theory cannot survive ad infnitum, and a new gen-
eration of academics will emerge from the failures of the old elite.
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