The weak-form efficient market hypothesis and behavioral finance theory are in contrast. The weak-from efficient market hypothesis states that, because all investors are rational and all historical information is already incorporated into current stock prices, no investor can consistently achieve returns higher than warranted by a stock’s risk. The behavioral finance theory states that investors are not rational. Therefore, the market cannot be efficient, thus it is possible to achieve excess return on the market. Behavioral finance theorists have disputed the efficient-market hypothesis both empirically and theoretically. Behavioral finance theorists point to ideas and concepts like gambler’s fallacy and winner’s curse as proof that investors are not rational.
There is proof that investors are not always rational. For instance, take gambler’s fallacy. Gambler’s fallacy is the belief that the more a specific outcome is observed in a series, the likelihood the opposite outcome will occur in the future increases. Investors fall victim to gambler’s fallacy when they sell a stock after its price has gone up a number of trading days because they feel further increase is unlikely. Conversely, investors might hold a stock after its price has fallen a number of trading days because they feel further decline is unlikely. Gambler’s fallacy is irrational because past events do not change the probability that events will occur in the future. Gambler’s fallacy, applied to investing, cannot coexist with the weak-form efficient market hypothesis. Weak-form states that all historical information is already incorporated in current stock prices, thus historical information cannot be profited from. If the weak-from efficient market hypothesis is correct, then buying and selling stocks is a game of chance rather than skill. A rational investor would consider a firm’s financial position, risk, and the effect of the portfolio before buying it. Despite gambler’s fallacy being irrational, investors sometimes behave this way.
Winner’s curse provides more proof that investors are not rational. Winner’s curse is the tendency for the winning bid in an auction to exceed the intrinsic value of the item purchased. Winner’s curse has a number of explainable causes including incomplete information and emotions. Regardless of the cause, the item being auctioned is awarded to the bidder with the greatest overestimation. Paying more for something than what is worth is not rational behavior. Theoretically, if markets were efficient, no overestimation would occur. However, the market has experienced overestimations and corrections. Stock bubbles, such as the dot-com or housing bubble, prove that people buy stocks at irrational prices beyond their true values.