Inefficient Markets and the New Finance
18 Pages Posted: 25 May 2005
By the early 1980s, the Efficient Capital Market Hypothesis (ECMH) had become one of the most widely-accepted and influential ideas in finance. More recently the idea of market efficiency has fallen into disrepute as a result of market events and growing empirical evidence of inefficiencies. This article, which is extracted from a longer essay, argues that the weaknesses of efficient market theory are and were apparent from inspection of its initial premises, including the presumptions of homogeneous investor expectations, effective arbitrage, and investor rationality. By the same token, a wide range of phenomena inconsistent with the ECMH can be explained using market models that modify these three assumptions. To illustrate, this article explores three important strands of today's finance literature: (1) work on asset pricing when investors have heterogeneous expectations; (2) scholarship on how and why arbitrage may move public information into prices more slowly and incompletely than earlier writings suggested; and (3) the exploding literature in "behavioral finance." Taken together, these literatures provide the framework for building a new and more powerful working model of securities markets.
Keywords: Efficient Capital Market Hypothesis (ECMH)
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