INTRODUCTION

There is one important caveat to the notion that we live in a new economy, and that is human psychol­ogy... which appears essentially immutable. - Alan Greenspan, September 4th, 1998

In Modern Finance literature, much of economic and financial theory is based on the notion that individuals act rationally and consider all avail­able information in the decision-making process.

The Efficient Markets Hypothesis (EMH) is one of the most crucial building blocks of modern

DOI: 10.4018/978-1-4666-6268-1.ch019

finance theory. The EMH argues that competition between investors seeking abnormal profits drives prices to their “correct” value. The EMH does not assume that all investors are rational, but it does assume that markets are rational. The EMH does not assume that markets can foresee the future, but it does assume that markets make unbiased forecasts of the future. In contrast, behavioral finance assumes that, in some circumstances, financial markets are informationally inefficient. Contrary to EMH theory, human decision-making is the starting point for behavioral finance.

.

First of all, this section will make a brief survey of conventional finance theory, focusing on the main topics of this area in literature. These main topic s include the following: non-behavioral finance built on the efficient market hypothesis; rational expectations hypothesis and random walk hypoth­esis. Then the link between market efficiency and security returns will be introduced with the help of empirical findings of previous studies from the literature. Finally the challenges to the efficient market hypothesis will be briefly discussed in order to show the possible direction for the future research in this area. And the concluding remarks are presented in the final section of this chapter.