Market Efficiency in an Irrational World

Kent Daniel and Sheridan Titman

No 7489, NBER Working Papers from National Bureau of Economic Research, Inc

Abstract: This paper explains why investors are likely to be overconfident and how this behavioral bias affects investment decisions. Our analysis suggests that investor overconfidence can potentially generate stock return momentum and that this momentum effect is likely to be the strongest in those stocks whose valuation requires the interpretation of ambiguous information. Consistent with this, we find that momentum effects are stronger for growth stocks than value stocks. A portfolio strategy based on this hypothesis generates strong abnormal returns that do not appear to be attributable to risk. Although these results violate the traditional efficient markets hypothesis, they do not necessarily imply that rational but uniformed investors, without the benefit of hindsight, could have actually achieved the returns. We argue that to examine whether unexploited profit opportunities exist, one must test for what we call adaptive-efficiency, which is a somewhat weaker form of market efficiency that allows for the appearance of profit opportunities in historical data, but requires these profit opportunities to dissipate when they become apparent. Our tests reject this notion of adaptive-efficiency.

JEL-codes: G1 (search for similar items in EconPapers)
Date: 2000-01
Note: AP
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (15)

Published as Kent Daniel & Sheridan Titman, 1999. "Market Efficiency in an Irrational World," Financial Analysts Journal, vol 55(6), pages 28-40.

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