Since Eugene Fame of the University of Chicago Graduate School of Business first proposed it in the early 1960s, the Efficient Market Hypothesis has been criticised. The main idea behind the Efficient Market Hypothesis is that investors understand and act on market news and information in a completely logical way (which, ostensibly, is fully revealed public knowledge).
Since then, people have called it the Theory of Rational Expectations. This makes investors act in a way that makes sense, and this is taken into account in the value of all news and information as soon as it becomes available. And it happens so much that it becomes impossible to "beat the market."
The few "gurus" who have consistently outperformed the market since its beginning have criticised the idea of rational investors. Daniel Kahneman, who won the Nobel Prize and is known as the "Father of Behavioral Finance," pointed out that the problem with the rational model is not with its logic, but with the human mind. He said that no one can process all incoming stimuli at the same time and get a full understanding and mastery of those stimuli.
I noticed that many of the arguments for and against the theory of rational expectations came from different ideas about what it means to be rational in the first place (indeed, that is further proof that "rational" people can look at ideas and apply their own bias and still be regarded as "rational"). People who disagree with the theory say that the world is made up of stupid people who make irrational decisions. If this is true, wouldn't the world be more like a group of monkeys? But if the theory is right and the world is made up of rational people, wouldn't it be more like a robot than a person?
Academics have been arguing about the theory for too long by taking sides with either the monkeys or the robots, without having a clear idea of what rationality is in the first place. Is it irrational for an investor to rush blindly into the stock market when it's going through a bubble? Are investors sane if they buy stocks that are undervalued and sell stocks that are overvalued? In the end, all reasonable people are rational! Rationality is doing the same thing over and over again based on a set of logical factors. The problem here is that everyone has a different set of logical parameters and values because of their different levels of knowledge and life experiences. This means that two people can look at the same information and interpret it in different ways, leading them to different conclusions and actions. Because of this, there are two sides to the market. If an investor has lost a lot of money on the stock market, they may not want to buy an overextended stock, no matter how good the news is. On the other hand, investors who have never been in the same situation would just keep buying based on what they heard in the news. In this case, both investors are reasonable based on how much they know and have done. This explanation of rationality brings together all the different ideas about the Theory of Rational Expectations in a way that makes sense. Because investors are smart, they create markets with two sides, which makes the market as a whole more and more efficient. Because investors are smart, they jump on price bubbles in hopes of making money, but the Law of Regression to the Mean makes them lose.
Being greedy is a reasonable response to one's needs and wants, and being afraid is a reasonable response to one's past pain. Greed and Fear are both driven by things that make sense. When contrarians go against the market, they are logically saying that they think the market will eventually turn against the current trend. When trend followers take positions that go with market trends, they are logically showing that they think that trend will continue for the near future. Both make a market for the other, which makes the market as a whole more and more efficient.
But this explanation of rationality completely destroys the part of the theory that says "rational investors should react the same way to the same news." No one can predict how the market will move with moral certainty because there is no way to measure or predict how many rational decisions to buy or sell will be made in response to new information. Even though the market is not random, it is hard to predict, and this has more causes and effects than the theory can explain.
In conclusion, any argument that uses the idea of rationality to explain how markets work has limited use in real life. As stock market investors, the most sensible things to do are to understand that the markets can't be predicted, set up realistic stop loss points to prepare for the worst-case scenario, and hedge portfolios with stock options (http://www.optiontradingpedia.com). Behavioral finance says that everyone makes the best of a bad situation, and the stock market has never been the perfect place for anyone.
