How Rational Investors Deal With Uncertainty
(Or, Reports of the Death of Efficient Market Theory Are Greatly Exaggerated)
Keith C. Brown
W.V. Harlow
Seha M. Tinic
Journal of Applied Corporate
Finance
2, 1989, pp. 45-58
Recent research on investor overreaction has called
into question the financial markets’ ability to react to new information
by moving quickly and smoothly (i.e., efficiently) to their new equilibrium
levels. In this paper, we discuss a
modification of the efficient markets hypothesis that is based, in part, on the
assumption that information is neither instantaneously nor costlessly
available to investors. The uncertain
information hypothesis (UIH) suggests that in response to surprise events that
add greatly to uncertainty about either specific firms or the market as a
whole, both the risk and required return to stockholders are expected to
increase. We provide evidence on the
reactions to more than 9,000 market-wide and firm-specific price change events
that strongly support this notion. We
conclude that it is premature to abandon the assumptions of investor
rationality and market efficiency in favor of loosely formulated alternatives.
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