Topics

• Behavioral Finance
• Efficient Market Hypothesis
• Adaptive Market Hypothesis
 Meaning of Behavioral Finance
• Behavioral finance is the study of the influence of psychology on the
behavior of financial practitioners and the subsequent effect on
markets.

• Behavioral finance is of interest because it helps to explain why and

how markets might be inefficient.
 Nature of Behavioral Finance
• Most people know that emotions affect investment decisions. People
in the industry commonly talk about the role greed and fear play in
driving stock markets. Behavioral finance extends this analysis to the
role of biases in decision making, such as the use of simple rules of
thumb for making complex investment decisions. Behavioral finance
takes the insights of psychological research and applies them to
financial decision.
 Nature of Behavioral Finance
• Behavioral finance studies the psychology of financial decision-
making.
• It makes the understanding of investment decision.
• It is the study of investor’s psychology.
• It is analytical in nature.
 Objectives of Behavioral Finance
• To study emerging issues in financial market
• To understand the psychology of the investors’
• To study the change in trends in investment
• To study the investment decision
• Develop the strategy of financial decision
• Study the scope of investment decision
Continued…..
Psychology
Psychology is concerned with all aspects of behavior and with the
thought, feelings, and motivation underlying that behavior.
Psychology is defined as the scientific study of human behavior with the
object of understanding why living being behave as they do.
 Efficient Market Hypothesis
All participants of exchange markets are rational economic subjects who
operate in conditions of free access to information that lets them to
accurately predict the future prices.
 Assumptions of Efficient Market Hypothesis
1.All new information incoming to market very quickly and almost
instantly reflected in the price
2.On the markets act rational economic subjects.
3.Stock markets are markets of perfect competition.
4.Expectations of market participants are homogeneous (same) .
5.Asset prices change according to the "law of a random walk."
 Key provisions of EMH
1.Market price always equals to the internal value of the asset.

2.It is impossible to take the economic decision that allows to get excess
profit (super profit).
 Practical inconsistencies in theoretical
principles of EMH
 - effects of "January", "Day of the week", "Small firms“
- history has hundreds and thousands of examples of the excess profits
obtaining.
- - central bank of Switzerland made a currency intervention to support
the depreciation of the Swiss franc.
- - overreactions and underreactios to certain information, volatility
explosions and seasonal bursts of return, yield dependence on different
variables such as market capitalization, dividend rate, market rates and
so on.
 Forms of Market Efficiency
1. Weak form prices include only the information contained in the
dynamics of the previous market prices.
2.  Semi-strong form all publicly available information - not just market
quotes and their historical values, but also various kinds of information
(macroeconomic statistics, news, commentary analysts forecasts, etc.)
that are relatively freely available.
3. Strong form publicly available information + internal information
about a particular asset (confidential data on the status of the company,
various trade secrets, important management decisions that have not yet
been announced.
 Alternative theories
1.psychological approaches to risk-taking behaviour (Kahneman and Tversky, 1979;
Thaler, 1993; Lo, 1999) - focus on the manner in which human psychology
influences the economic decision-making process as an explanation of apparent
departures from rationality;
2) evolutionary game theory (Friedman, 1991) - studies the evolution and steady-
state equilibria of populations of competing strategies in highly idealized settings;
3) agent-based modelling of financial markets (Arthur et al., 1997; Chan etal., 1998)
- meant to capture complex learning behavior and dynamics in financial markets
using more realistic markets, strategies, and information structures;
4) direct applications of the principles of evolutionary psychology to economics and
finance (Lo, 1999; 2002; 2004; 2005; Lo and Repin, 2002) provide a reconciliation
of rational expectations with the behavioral findings that often seem inconsistent
with rationality. 
 The Market Efficiency Debate: Anomalies
• An issue of great debate between finance traditionalists and
behaviorists is whether or not markets are efficient.

• Traditionalists contend that markets are efficient in the sense that

departures from efficiency are temporary, small, and infrequent.

13
Continued……
• Behaviorists contend that because of the behavioral phenomena, there
are particular circumstances in which departures from efficiency are
likely to be large and occur for long periods of time.

14
 Adaptive Market Hypothesis
• The adaptive market hypothesis (AMH) is an alternative economic
theory that combines principles of the well-known and often
controversial  efficient market hypothesis(EMH) with behavioral
finance. It was introduced to the world in 2004 by  MIT professor
Andrew Lo.
• Andrew Lo, believes that people are mainly rational, but sometimes
can overreact during periods of heightened market volatility.
• AMH argues that people are motivated by their own self-interests,
make mistakes, and tend to adapt and learn from them.
Continued……

• The AMH attempts to marry the theory posited by the EMH that markets
are rational and efficient with the argument made by behavioral economists
 that they are actually irrational and inefficient.

• For years, the EMH has been the dominant theory. The strictest version of
the EMH states that it is not possible to "beat the market" because
companies always trade at their fair value, making it impossible to buy 
undervalued stocks or sell them at exaggerated prices.
Continued…..
• Behavioral finance emerged later to challenge this notion, pointing out
that investors were not always rational, and stocks did not always
trade at their fair value during financial bubbles, crashes, and crises.
Economists in this field attempt to explain stock
market anomalies through psychology-based theories.
• The AMH considers both these conflicting views as a means of
explaining investor and market behavior. It contends that rationality
and irrationality coexist, applying the principles of evolution and
behavior to financial interactions.
 How the Adaptive Market Hypothesis (AMH) Works

• Lo, the theory’s founder, believes that people are mainly rational, but sometimes
can quickly become irrational in response to heightened market volatility. This can
open up buying opportunities. He postulates that investor behaviors—such as loss
aversion, overconfidence, and overreaction—are consistent with evolutionary
models of human behavior, which include actions such as competition, adaptation,
and natural selection.
• People, he added, often learn from their mistakes and make predictions about the
future based on past experiences. Lo's theory states that humans make best
guesses based on trial and error. This means that, if an investor’s strategy fails,
they are likely to take a different approach the next time. Alternatively, if the
strategy succeeds, the investor is likely to try it again.
Continued…..
• The AMH argues that investors are mostly, but not perfectly, rational.
They engage in satisficing behavior rather than maximizing behavior,
and develop heuristics for market behavior based on a kind of natural
selection mechanism in markets (profit and loss). This leads markets to
behave mostly rationally, similar to the EMH, under conditions where
those heuristics apply.
• However, when major shifts or economic shocks happen, the
evolutionary environment of the market changes; those heuristics that
were adaptive can become maladaptive. This means that under periods
of rapid change, stress, or abnormal conditions, the EMH may not hold.
Criticism of Adaptive Market Hypothesis (AMH)

Academics have been skeptical about AMH, complaining about its lack
of mathematical models. The AMH effectively just echoes the earlier
theory of adaptive expectations in macroeconomics, which fell out of
favor during the 1970s, as market participants were observed to most
form rational expectations. The AMH is essentially a step back from
rational expectations theory, based on the insights gained from
behavioral economics.
 EMH Vs AMH
EMH
The efficient market hypothesis
was developed by Eugene Fama
who claims that it is impossible to
conquer the market since stocks
always sell at their best fair price.
This makes it difficult for the
investors to sell stocks at inflated
prices and also it is impossible to
purchase low valued stock.
AMH
• Adaptive market hypothesis is a model
which combines the principles of the
effective market hypothesis with those of
behavioral finance.
•  The hypothesis states that people make
the best prediction on trial and error
bases. For instance, an investor may
come up with a certain strategy and use
it, if the strategy succeeds, the investor is
likely to use it again but if it fails, he is
likely to try a different approach.
 Activity

Write down five practical implications of EMH and AMH and point out
the distinguish features.