Further, as Kahneman and Riepe (1998) note, “people deviate from the standard decision making model in a number of fundamental areas. We can group these areas, somewhat simplistically, into three broad categories: attitudes toward risk, non-Bayesian expectation formation, and sensitivity of decision making to the framing of problems.” (Shleifer, 2000, p.10) In terms of individuals’ attitudes toward risk, the precepts of Neumann-Morgenstern rationality hardly ever holds good. Empirical evidence suggests that investors look not at the overall returns that they could avail through a stock, but instead look at gains in the backdrop of an arbitrary reference point they’ve set. This reference point that denotes their perception of good and bad performance depends on numerous prevailing circumstances. They also
“display loss aversion—a loss function that is steeper than a gain function. Such preferences—first described ‘Prospect Theory’—are helpful for thinking about a number of problems in finance. One of them is the notorious reluctance of investors to sell stocks that lose value, which comes out of loss aversion). Another is investors’ aversion to holding stocks more generally, known as the equity premium puzzle.” (Shleifer, 2000, p.10)
Another phenomenon that counteracts the theory of efficient markets is the systematic violation of some theories of probability (including the Bayes rule). This manifests in investors’ predictions of uncertain outcomes. For instance, market players usually base their predictions on analyzing short history of price movements and try to understand what broader picture this history is representing. But such an understanding betrays the fact that they are not paying sufficient attention to the “possibility that the recent history is generated by chance rather than by the ‘model’ they are constructing. Such heuristics are useful in many life situations—they help people to identify patterns in the data as well as to save on computation—but they may lead investors seriously astray.” (Shleifer, 2000, p.11)
In conclusion, despite being a popular theory during the 1970s and 1980s, the EMH’s basic premise that stock value is fully reflected in quoted price has not stood the tests of time. As a result, few people talk of EMH with any degree of conviction. The market crash of October1987 was a major blow to believers in EMH. This event raised this important question: ‘How could the fundamental value of the stocks on the New York Stock Exchange fall almost twenty-five percent in two days when no significant macroeconomic event could be identified?’ As no analyst has since presented a satisfactory answer to this question, the theory’s grander aspirations remain far off. (Shleifer & Summers, 1990, p.704) Further, the pricing of Internet securities and the crash that followed should be
“a fatal blow to the idea that security markets could effectively segregate the effects of noise traders and thus should be the end to the claim that market price and fundamental value are synonymous in an active securities market. Even financial economists now customarily use the term “bubble” to refer to the late 1990s stock market or elements of it. And while asset bubbles present mysteries of their own, they are of course quite incompatible with the supposed fact that prices in securities markets result from a rational incorporation of all available information bearing on value.” (Allen, 2003, p.551)