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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