Gilson and Kraakman suggest another explanation for market inefficiency –that of “uninformed” trading. They assert that even if all investors had the same opportunity and facilities to access information relating to securities, one category of information remains out of their reach, namely, the prediction of future events and price movements. Consequently, investors tend to disagree in terms of their forecasts. But this disagreement is not a trivial matter in the securities market, as the following passage suggests:
“Securities are nothing more than claims to a stream of future income, so minor disagreements in predictions can lead to major disagreements about valuations. Nevertheless, investors’ divergent forecasts may not lead to inaccurate securities prices, so long as mistakes in forecasting are random. In other words, the random biases of individual forecasts will cancel one another out, leaving price to reflect a single, best-informed aggregate forecast.” (Stout, 2003, p.636)
When we add human emotion to the mix of factors affecting decision making, then the projected trajectories of future earnings can vary widely from one analyst to another. Hence, another criticism of EMH comes from the staples of Behavioural Finance, which shows how otherwise rational people often times make irrational choices. This is as true in the domain of financial markets as in any other human activity. The basic insight offered by scholars of Behavioural Finance is that
“human emotion and error can influence investment choices just as they influence choices to play lotteries or wear seatbelts. The trick, of course, is to figure out in advance just how this influence operates. To do this, behavioural finance theorists rely on the psychological literature, and especially on empirical studies of human behaviour in experimental games, to identify predictable forms of “cognitive bias” that lead people consistently to make mistakes. They then examine whether these systematic biases can help explain or predict empirically-observed market anomalies that cannot be explained or predicted by rational-actor-based traditional finance.” (Stout, 2003, p.639)
More explanations for inaccurate stock valuations are to be found in empirical research on specific stock market data. In an interesting study on the behaviour of the Austrian Stock Market, researchers Darrol J. Stanley and Bruce A. Samuelson find that the EMH generally works, but still throws up paradoxes on a regular basis. (Stanley & Samuelson, 2009, p.183) Some other theoretical challenges to the EMH are laid out below. Firstly, it is difficult to maintain the case that market participants are fully rational in the choices they make. As Fischer Black (1986) have identified, traders (especially) tend to trade on noise rather than substance. Lay investors too, in their own way, act on advice acquired from an investment guru who’s in fad. Lay investors are also susceptible to the habit of diversifying inadequately, churning over stocks too frequently in their portfolio, and to hold onto losing stocks on the back of hope as against real prospects, etc. There is also the tendency to buy mutual funds that charge a heavy fee and to follow stock quotations obsessively. All these behaviour patterns of investors, lay and professional alike, suggest that they barely pursue passive strategies expected of uninformed market participants by the efficient markets theory. (DeBondt & Thaler, 1987, p.6)