Then anyone interested in selling and buying would sell and buy at an adjusted price, so the price rises. It means that the adjusted price fully absorbs the information and it follows the efficient market. Instead, If Investors are not rational, the shock market will fail to be efficient. As we consider Irrational Investor cannot price the stock correctly, stock price fall to reflect all available Information. In other words, Irrational Investors can violate market In fact, it is idealistic that all investors need to behave rationally.
Market is still efficient if another two situations hold. As mentioned above, it is true that people in general do demonstrate behavioral biases or irrationality. Besides, investors are influenced by many kinds of biases when making decision. One of the biases that plague many investors Is overconfidence. From SFA Investment Course, we know that confidence can easily turn Into overconfidence after a few easy wins. For many beginners, the first few stocks they pick always perform extremely well. However, they start thinking they are smarter then other.
And this often leads to failure. There is another explanation of overconfidence, according to Daniel, Horseflies and Superhumanly, individuals place much weight on the information collected by them as they have confidence in the accuracy of the information. They are misled by their overconfidence, thus underweight the information provided by experts. Moreover, according to Barry Rituals, one of the behavioral biases investor made is confirmation bias. It Is a bias that people tend to reach a conclusion first before gathering and evaluating facts and data.
And people gather facts and believe those facts as supporting their pre-conceived conclusions. In addition, home bias is another common bias in making investment decision. Home (1991), a typical Japanese investor held 98. 1% in Japanese stocks, and this also happened on U. S. And U. K. Investor as well. Although the cases may be sound extreme, it proves that investors usually feel optimistic of their local market, when comparing with foreign markets. The reason behind is that more information about local market is available for local investors.
Lastly, Anchoring, suggested by Robert Stammers, is the idea of becoming obsessed on past information and using it to make inappropriate investment decisions. Investors are not able to “get their mind off’ a particular sell-price target, though the investing landscape has shifted significantly or new information is available. Consequently, they become stuck and ride markets to the bottom. We only suggest five biases investors may have; yet, there are still many biases when people make decision. As investors cannot always get perfect information on hand, hey will be affected by different kinds of biases.
If at least some investors/traders demonstrate behavioral biases or irrationally, the stock market can still be efficient. According to the definition, market efficiency means the stock price fully reflects available information. Investors with irrational behaviors or investment biases may buy and sell the stocks higher or lower than right price. Especially, investors influenced by investment biases tend to buy stocks even if stock is in right price. Hence, stocks are overpricing or underpinning because of excessive or insufficient emend.
This makes market inefficient. Nevertheless, market could remain efficient as long as some rational investors existing in the market. According to Shellfire, smart money will react to the irrational investment. Smart money will buy the underpinned stocks and sell the overpriced one, thereby eliminate the effect of irrational investment in the market. Stocks are therefore adjusted to correct price, and market maintains it efficiency. In real world, there are numbers of investors having investment biases and behaving irrationally.
They make incorrect prediction due to overconfidence and other investment biases, and their investments are based on emotion. In brief, it implies that stock price exhibit certain degrees of inefficiency or irrationality. There is a real case suggesting the above statement. On 15 October 2009, IBM made an announcement of quarterly earnings of $2. 40 per share. Analysts previously had predicted should be $2. 38, so the announcement was 2 cents higher than the estimates. On that day, Vim’s stocks rose immediately by $3. 58. Ironically, IBM led a market retreat by falling $6. On the next day. The market exaggerated to the positive earning news supplemented by a revised full-year earnings estimate. However, the next day, the market collectively reevaluated its overreaction and sold behavior in the market. Incidents such as market-wide crashes and the dotcom bubble of the late ass reveal some sort of inefficiency within the markets. The price bubbles indicates the stock prices reflect inefficiency. Market bubbles exist because of inefficiency in pricing of individual stocks and of the whole market.
In the market, speculators are active in seeking high returns with high risk and short-term positions. As a result, in 2008, when prices tumbled, many well-managed companies lost value in their stock. To conclude, it is not practical to consider all investors are fully rational. People are easily affected by behavioral biases, such as overconfidence. Thus, the stock prices exhibit certain degrees of inefficiency or irrationality. The controversial part is whether the stock market efficiency is still held under such condition. The market is still efficient as long as some rational investors exist in the market.
