From the Efficient Market Hypothesis to Prospect Theory

This chapter describes the shift from the Efficient Market Hypothesis to Prospect Theory in order to give the new trader a mini review of the background thinking relating to the equity markets. The Efficient Market Hypothesis (EMH) assumes that investors and traders act rationally at all times and that information is equally and instantly distributed among them and is immediately reflected in the price of the stock. This line of thought would make TA unusable and in the end would make trading itself impossible as all information would be priced into the market and there would be no incentive for traders to buy or sell as there could be no disagreement on price. The core of the prospect theory states that when faced by choices among risky and uncertain outcomes, prospects show effects that are totally inconsistent with basic utility theory. In prospect theory, loss aversion refers to people's tendency to strongly prefer avoiding losses to acquiring gains.