The Efficient Market Hypothesis of Fama and Festinger's Cognitive Dissonance

Abstract

The role of bias in investor's decision making is no more a subject of debate. Empirical evidence supporting the influence of bias amongst investors is growing since the 1980s. This paper is an attempt to understand the concept of cognitive dissonance given by Festinger¹¹(1957) which laid the foundation for the study of investor bias. It discusses Eugene Fama's Efficient Market Hypothesis which is all pervasive in finance literature and the challenges it confronts from the growing field of Behavioural finance. The paper reviews earlier empirical studies on cognitive bias amongst the representative agents, to understand the influence of bias and irrationality among investors. The first section of the paper gives the theoretical background to efficient market hypothesis and the concept of cognitive dissonance. The second section discusses the implications of bias on the investor's decision making, followed by a review of studies to support the claim. The study concludes by emphasizing the need for investors to understand the influence of bias and prevent themselves from succumbing to psychologically induced errors.