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Efficient Markets Theory and Behavioral Finance - Essay Example

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Efficient Markets Theory and Behavioral Finance

In this theory, therefore, assumptions are done perpetuating that the information organisation and the behaviour of market participants systematically control individuals’ decisions in investment and the outcomes of the market. According to (Malkiel, 2003) the efficient market theory, has implications of theoretical perspectives to the market trends, while it ignores or under estimate the practical perception of the market. On the other hand, the behavioural finance theory has been thought of being more practical based and focused on people’s behaviour (Ashta & Patil, 2007). Following the event of the financial crises in 2007 to 2010, contention has developed amongst various authors on its implication to popularity of the already criticised efficient markets theory and its contribution to the upsurge of the prevailing interest in behavioural finance theory. This paper compares and contrasts the explanations of efficient market theory and behavioural finance with regard to the financial crisis 2007 to 2010 and identifies the explanation considered to be strongest. Efficient market theory versus behavioural finance theory and the 2007 to 2010 financial crisis The efficient market theory upholds the notion about the randomness in stock prices, based on short-run serial relationships amid successive changes in stock prices (Malkiel, 2003). Such was the case in the year 2001 when the US economy experienced a recession, followed by a boom that led to the dotcom bubble, and accounting scandals. The behavioural market theory regarded such occurrences in a different way from that of the efficient market theory, in that, the fears in individuals’ mind of recession was considerable. Therefore, in regarding to the recession in 2001 being disregarded, the stock market was thought of as not having a memory of the way the price of a stock behaved in the past, so as to determine its future behaviour. The randomness in efficient market theory is questionable, due to the high frequencies with which successive moves towards the same direction occurred in the period of 2001 and 2003 when subprime mortgage grew from 2001 to 2005 (Fligstein, 2011). The efficient market theory is regarded as the main contributor to the 2007 – 2010 financial crises. According to European Economy (2009) there had been some momentum in the short-run prices of stock (Lee & Lee, 2010). In founding the foregoing argument, the campaigners of the efficient market theory have applied some sophisticated nonparametric numerical methods, able to identify patterns and certain signals in stock price and achieved some diffident projecting power. The bubble of the subprime mortgage was recorded to have expanded in 2001 from approximately $173 billion to $665 billion year 2005 (Kan & Andresso-O’Callaghan, 2007). The market information available then indicated increment of this industry with success and mortgage organizations were tied together as decision makers in money lending institutions and investors made risky decisions. The behavioural finance theory was further decremented by the loan defaulters, evidenced within the pre crisis era. The eventual bursting of the mortgage bubble brought down several other organisations, thereby, creating a clear cut distinction between the behavioural and the effective market theory. The changing in the prices of the housing industry was big factor to the 2007 -2010 financial crisis, where mortgages took control of the financial ...Show more
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Summary

EFFICIENT MARKETS THEORY AND BEHAVIOURAL FINANCE Name Affiliation Lecturer Date Introduction Efficient market theory is a theory used in investment that upholds the argument that the market cannot be beaten easily as the efficiency in the market causes existing stock prices to utilize and reflect all useful information…
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