According to Fama (1970), a market in which prices always fully reflect available information can be regarded as efficient. Market efficiency theoretically rests on three supports, which is investor rationality, uncorrelated errors and unlimited arbitrage. If three of them fail, it is questionable whether market is still running efficiently or not. Therefore, stock market efficiency requires every investor to be rational. If investors are not rational, the stock market will not be efficient. It is because irrational investors’ behavior cannot make stocks correctly priced.
In other word, stock price does not reflect all available information which means violation of market efficiency. Only when investors are rational can stock prices reflect all available information. For example, if a company enounces favorable news, rational investors will buy the stock immediately to get a profit and the stock price will be adjusted accordingly. After that, the stock price of that company will reflect all available information including the newly enounced information. Therefore, stock market is still efficient.
However, if investors are irrational, there is no way to predict what action they will take after new enouncement of information. Stock market can be inefficient or efficient after enouncement of new information depending if investors are rational or not. However, we know that it may be too unrealistic for all investors to behave rationally; market still efficient if another two supports hold. (Ackert Lucy, 2010)There must be some biases when people make investment decision, as normal humans are imperfect. There are lots of different kinds of biases when making investment decision.
Home bias is one of the biases in making investment decision. Home bias indicates that investors tend to overvalue domestic stocks. According to French (1991), a typical Japanese investor held 98. 1% in Japanese stocks; a typical U. S. investor held 93. 8% in U. S. stocks; and a typical U. K. investor held 82% U. K. stock. The existence of this bias is because investors usually feel optimistic of their local market compared to foreign markets. More information available for local market may also be a reason for the existence of this bias.
Moreover, people also have a bias to overweight the stock prices of familiar brands. According to Laura (2005), institutional holdings are significantly and negatively related to brand recognition, but no discernible impact is present for brand quality. It means people have a high demand for firms with good brand names. This bias can be explained by information advantage of firm with good brand name. I have only mentioned two biases, and there are still many biases in making investment decision, such as overweighting investment on industry which investors themselves are in.
However, major reason of bias is due to informational advantage of that area. As Humans are imperfect and do not have perfect information, they will be affected by different kinds of biases when making investment decision. If at least some investors/traders demonstrate behavioral biases or irrationality, the stock market can still be efficient. Efficient market means stock prices have already reflected all available information. In other words, they are correctly priced. For irrational investors, they may buy or sell a lot of stocks that are already correctly priced.
For investors having investment biases, they tend to buy stocks which they prefer continuously even if they were in the right prices. Both behavior mentioned before may lead to over-pricing or under-pricing of stocks due to excessive demand or insufficient demand. This means the existence of market inefficiency. However, as long as there are still some rational investors knowing that the stock has been overpriced or underpriced, they will try to buy underpriced stocks and sell overpriced stocks.
Finally all prices will back to original level and become correctly priced. Therefore, market can still be efficient even though there are some investors demonstrate biases or irrationality However, as I have mentioned before, it may be too unrealistic for all investors to behave rationally. Therefore, market efficiency only required one of three supports (Investor rationality, uncorrelated errors and unlimited arbitrage). Even all investors are irrational or having behavioral biases, market can be efficient if one of another two supports hold.