An efficient market is a market in which prices can always fully reflect available information. According to Andrei Shleifer, Market efficiency is theoretically based on three conditions, which are investor rationality, independent deviations from rationality and unlimited arbitrage. If three conditions cannot be satisfied, the market might be not efficient. Thus, investors’ rational behavior leads to stock market efficiency.
For instance, when a company releases new information, for all investors, they will adjust their estimates of stock prices in a rational way. 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 fail to reflect all available information. In other words, irrational investors can violate market efficiency.
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 CFA 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, Hirshleifer and Subrahmanyam, 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...
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