Efficient Markets Hypothesis or Behavioral Economics?

This comprehensive article examines how the efficient market hypothesis (EMH) shaped the financial models that contributed to the current economic recession. As the movement behind behavioral economics continues to grow, many people are asking which theory describes reality better. EMH assumes that the price of a financial asset takes into account all relevant information and is very close to the actual value of the asset. Following this assumption, many new financial models were developed that all rested upon the idea that prices never strayed from equilibrium for long. Banks decided to keep less capital on hand to cover their risk because a “bubble” would not occur according to EMH. When the market did crash, there were not enough assets to cover all the losses and banks failed. Some see this as proof that EMH does not explain the market’s actions accurately and they suggest that behavioral economics can better describe what happened. Describing the actions of thousands of individual sellers and buyers is a lofty goal for any theory, to be sure. But it is important that we step back and investigate why things happened like they did so we can know what to look for in the future. Whether the current recession was due to bad models or poor judgment it is clear that we are not yet able to “see” most of what is going on in our economy.