Efficient Market Hypothesis Vs. Behavioural Finance: What Investors Need to Know

Let us imagine a scenario. Suppose you are in a bustling market and the prices in every shop seem to respond instantly to changing demand. So, if a particular spice becomes popular, its price go instantly upwards. Similarly, if a fruit spoils, its price drops. This seems almost magical in its efficiency.

Now, imagine shoppers rushing, panicking, buying in clusters and sometimes behaving irrationally due to this dynamic pricing. Can a market be organised and chaotic at the same time?

The debate between the Efficient Market Hypothesis (EMH) and behavioural finance is the longest-running debate in modern finance. While the Efficient Market Hypothesis suggests that stock prices reflect all available information – therefore functioning efficiently – behavioural finance highlights how real people with emotions, biases and imperfect decisions can cause prices to deviate from their intrinsic value. For an investor, it becomes important to understand the balance between these two viewpoints.

In this article, we will study both sides by understanding Efficient Market Hypothesis (EMH) in its three forms and explore the behavioural angle.

Table of contents

• What is the efficient market hypothesis?
• The EMH is explained in three forms:
• The behavioural critique: How biases and irrational trading distort markets
• The Prospect Theory (Kahneman & Tversky) is a key concept
• Investor lesson: Efficiency as baseline, psychology explains deviations

What is the efficient market hypothesis?

Although the roots of the Efficient Market Hypothesis (EMH) trace back earlier, it was Eugene Fama’s research in the 1960s that formalized and brought the concept into mainstream financial theory. The hypothesis says that financial markets are inherently efficient, which means that stock prices already reflect all the information available. This means it’s very hard for investors to consistently “beat the market” through stock-picking or timing, because prices quickly adjust when new information appears.

The EMH is explained in three forms:

• Weak form: Current prices already include past price trends and trading volumes.
• Semi-strong form: All publicly available information is quickly reflected in stock prices.
• Strong form: Prices reflect every kind of information which is both public and private.

While EMH assumes that investors always act rationally and information spreads perfectly, behavioural finance shows that people often make decisions based on emotions and biases, which can create inefficiencies in the market.

Also Read: Behavioral Finance: Meaning, Types, and Its Importance

The behavioural critique: How biases and irrational trading distort markets

The roots of behavioural finance trace back to the late 1970s, when psychologists Daniel Kahneman and Amos Tversky introduced Prospect Theory, highlighting systematic biases in human decision-making. Their research demonstrated that people value gains and losses differently, leading to irrational decision-making. Richard Thaler further advanced the field by integrating psychological insights into economic models, earning him a Nobel Prize in Economics in 2017.

Essentially, behavioural finance merges psychology and economics to explain how investors make decisions. It acknowledges that investors aren’t always rational and can be influenced by emotions and cognitive biases. It challenges traditional finance theories, like the Efficient Market Hypothesis (EMH).

The Prospect Theory (Kahneman & Tversky) is a key concept

• The Prospect Theory says that investors make decisions based on gains and losses relative to a reference point. Further, people are risk-averse for gains but risk-seeking for losses.
• People treat money differently depending on its source or purpose. For instance, they are more willing to take risks with “found money” (like tax refunds, bonus etc.) than with earned income.
• Some investors tend to overestimate their knowledge and abilities. This can lead to excessive trading, poor diversification, and weak risk management.
• Humans tend to seek information that supports pre-existing beliefs. This leads to ignoring contradictory evidence and making potentially suboptimal investment decisions.
• Humans often follow the crowd instead of using their individual judgment. This can contribute to market bubbles and crashes.
• Pain from losses feels stronger than pleasure from equivalent gains. This may lead investors to hold losing investments too long and sell winners too soon.
• People also have a tendency to rely heavily on an initial reference point, based on which they make further decisions. For instance, investors fixate on a stock’s purchase price and hesitate to sell at a loss.

Examples: Market bubbles and anomalies

Dot-com bubble (late 1990s)

Investors got overly excited about tech stocks, expecting unrealistic future growth. When reality hit, the NASDAQ plummeted between 2000 and 2002.

2008 financial crisis

Herd behaviour and overconfidence among investors contributed to the housing bubble and the subsequent market crash.

GameStop short squeeze (2021)

Retail investors on online forums bought heavily into GameStop, a struggling video game retailer. Prices soared far beyond intrinsic value, driven more by group psychology than fundamentals.

Read Also: Behavioural Finance: Thinking Process Versus Outcome

Investor lesson: Efficiency as baseline, psychology explains deviations

While EMH proposes an idealised world and behavioural finance explains human emotions, the real question is––what should investors take away? Here are the key points:

Markets can be reasonably efficient, but not perfect

An investor must accept that markets are not perfectly efficient in every moment. EMH provides a useful baseline: prices often reflect much information and behavioural explain deviations. Thus, investors may assume a degree of market efficiency, but remain alert for periods where irrationality can push prices off track.

Focus on process, not trying to beat the market

On one hand, where EMH suggests that consistent outperformance is difficult, behavioural finance identifies potential opportunities where irrational behaviour may create inefficiencies.

Portfolio diversification

Behavioural finance shows that overconfidence and favouring familiar investments may be risky, so spreading investments across different assets is important. EMH also supports diversification to reduce risks that are specific to individual stocks.

Risk management

Knowing that investors feel losses more strongly than gains can help in creating portfolios that match comfort with risk.

Maintain a long-term view

Historically, mispricings and behavioural distortions have corrected over time (past performance may or may not be sustained in future). A long horizon may allow mean reversion and fundamental forces to reassert. Short-term noise, speculation and emotion often dominate, but over the years, fundamentals may matter more. Combining data-driven analysis with self-awareness, patience, and a long-term perspective may be a suitable strategy.

Be humble, stay curious

Markets are complex adaptive systems, where efficiency and irrationality interact. An investor’s humility and realising the limits of knowledge and forecasting are valuable. Continually learning behavioural insights helps in staying vigilant.

Also Read: Impact of Behavioural Finance on Market Conditions

Conclusion

Markets may be relatively efficient much of the time but are not immune to human emotions and irrational waves. While market efficiency may ensure that information is quickly reflected in prices, behavioural insights remind us that fear, greed, and herd instincts may still distort valuations. By blending knowledge of market efficiency with awareness of investor behaviour, one may make informed decisions.

At Bajaj Finserv AMC, we recognise that emotions are the cornerstone of investor behaviour – not just for investors but for investment professionals too. That’s why, behavioural finance is at the heart of our investment philosophy, InQuBe, which combines the Information Edge, Quantitative Edge and Behavioural Edge. By understanding, tracking and monitoring market sentiments and our own investment biases, we seek to make mindful and strategic investment decisions. Get the Behavioural edge by investing with Bajaj Finserv AMC. Read more about InQuBe here.

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