NISM-Series-X-B: Investment Adviser (Level 2) · Basics of Behavioural Finance

Traditional Finance and the Efficient Market Hypothesis

Q: What are the three forms of the efficient market hypothesis?

The weak form says prices reflect all past price and volume data. The semi-strong form says they reflect all public information. The strong form says they reflect all public and private information.

Q: Which form does insider trading profit contradict?

Consistent profit from insider information contradicts the strong form. The semi-strong and weak forms can still hold. This is why the strong form is seen as the hardest to defend.

Q: How is expected utility theory different from prospect theory?

Expected utility theory assumes rational, risk-averse investors who judge final wealth. Prospect theory says people judge gains and losses from a reference point and feel losses more strongly than equal gains.

Q: What are market anomalies?

They are patterns in returns that are hard to explain if markets are efficient. Examples are the January effect, small-firm effect, value effect and momentum. They are used to question EMH, though some can be explained by risk or costs.

Updated 11 October 2026 · Fact-checked

Traditional finance assumes investors are rational, maximise expected utility and price assets correctly. The efficient market hypothesis says prices already reflect available information. Weak form covers past prices, semi-strong adds public information, strong adds private information. To solve questions, match the information set to the form, then check which anomaly contradicts it.

Understand Traditional Finance and Efficient Market Hypothesis

Traditional finance starts from one idea: people are rational. A rational investor has clear preferences, uses all available information, updates beliefs correctly and picks the option that gives the best outcome for their risk attitude. Markets are then made of such investors, so prices should be fair.

Expected utility theory is the tool used to model this choice. The investor does not look at money alone. They look at the utility (satisfaction) of each possible outcome, weight it by its probability, and choose the option with the highest expected utility. Most investors are assumed to be risk averse: extra wealth adds less utility each time (diminishing marginal utility). Final wealth matters, not gains or losses from a reference point. This is the point where behavioural finance later disagrees, because prospect theory shows people judge outcomes as gains and losses from a reference point and feel losses more.

The efficient market hypothesis (EMH) follows from rationality. If many rational investors compete for profit, any new information is quickly reflected in the price. So prices follow new information, which is unpredictable, and price changes are essentially random. It comes in three forms, based on the information set already in the price.

Weak form: prices reflect all past price and volume data. Technical analysis cannot earn consistent excess returns.
Semi-strong form: prices reflect all publicly available information, including past prices, results and announcements. Fundamental analysis on public data cannot earn consistent excess returns.
Strong form: prices reflect all information, public and private (insider). Even insiders cannot earn excess returns.

Each form includes the one before it. If the strong form holds, the semi-strong and weak forms hold too.

Behavioural finance points to anomalies: patterns that are hard to explain if markets are efficient. Examples are the January effect, the small-firm effect, the value effect (low price-to-book or low P/E stocks doing better), momentum, post-earnings-announcement drift, bubbles and crashes. Defenders of EMH reply that some anomalies may reflect extra risk, data mining or costs that remove the profit. Note that EMH does not say every investor is rational at all times. It says prices cannot be consistently beaten.

Key formulas to remember

Expected utility: EU = Σ [pᵢ × U(xᵢ)]; pᵢ is the probability of outcome i and U(xᵢ) is the utility of that outcome. A rational investor picks the highest EU.
Risk-averse utility: U′(W) > 0 and U″(W) < 0; More wealth is preferred, but each extra rupee adds less utility. This is diminishing marginal utility.
Weak-form EMH: Price reflects past prices and volume; Technical analysis fails to give consistent excess returns.
Semi-strong EMH: Price reflects all public information; Fundamental analysis on public data fails. Insiders may still gain.
Strong-form EMH: Price reflects all public and private information; Even insider information gives no excess return.
Nesting of forms: Strong ⊃ Semi-strong ⊃ Weak; If a stronger form holds, all weaker forms hold. If the weak form fails, the stronger ones fail.

How to solve Traditional Finance and Efficient Market Hypothesis questions

Use this method for any question on rationality, utility, EMH forms or anomalies.

1Identify what the question tests: a rational-investor assumption, expected utility, an EMH form, or an anomaly.
2If it is an EMH question, list the information used in the strategy: past prices, public data, or insider data.
3Match that information to a form. Past prices point to weak, public data to semi-strong, private data to strong.
4Remember the nesting. A strategy that works on public information breaks the semi-strong form and so the strong form too.
5For utility questions, compute probability × utility for each outcome, add them, and pick the highest total.
6For anomaly questions, ask which claim the pattern contradicts, for example a predictable calendar pattern contradicts the weak form.
7Eliminate options with words like always, never or only, and options that mix up traditional finance with prospect theory.

Quickest way: Information-set shortcut

When to use it: Use it when a question describes a strategy or event and asks which EMH form is violated or supported.

Ask: what information does the strategy use?
Past prices or charts: weak form.
Published results, news, ratios: semi-strong form.
Insider or non-public tips: strong form.
If a strategy using a narrower set earns excess returns, the form for that set and all wider forms fail.

Common mistakes in Traditional Finance and Efficient Market Hypothesis

Saying technical analysis works under the semi-strong form.
Students forget that each form includes the narrower one.
Fix: If past prices are already reflected, which is the weak form, then chart patterns are useless under semi-strong and strong forms too.
Believing insiders can earn excess returns under the strong form.
Insider information sounds like an advantage.
Fix: The strong form says even private information is already in the price. Insiders gaining means the strong form fails.
Thinking EMH says all investors are rational.
EMH is linked to rational-investor assumptions.
Fix: EMH says prices reflect information and cannot be consistently beaten. Some investors may be irrational, but they do not move prices in a lasting way.
Mixing expected utility theory with prospect theory.
Both deal with decisions under risk.
Fix: Expected utility looks at final wealth and assumes rational, risk-averse choice. Prospect theory uses gains and losses from a reference point and loss aversion.
Treating an anomaly as proof that EMH is false.
Anomalies are presented as challenges to EMH.
Fix: Say they question EMH. Supporters explain them by risk, data mining or transaction costs.
Reading expected utility as expected money value.
Both use probability-weighted sums.
Fix: Expected utility weights utility, not rupees. A risk-averse person may reject a fair gamble.

Worked examples

Example 1

An analyst earns consistent excess returns by buying shares of companies right after publicly announced quarterly results show strong profit growth, before the price fully adjusts. Which form of EMH does this contradict at the minimum, and which forms stay untested?

Show the solution

The information used is publicly announced results.
Public information corresponds to the semi-strong form.
Excess returns from public information mean the semi-strong form fails.
Because strong form includes semi-strong, the strong form also fails.
The strategy does not use past prices, so it does not by itself test the weak form.

Answer: It contradicts the semi-strong form, and therefore the strong form as well. The weak form is not tested by this strategy.

Example 2

An investor with utility function U(x) = √x (x in ₹ lakh) chooses between Option A: a sure ₹9 lakh, and Option B: a 50% chance of ₹16 lakh and a 50% chance of ₹4 lakh. Using expected utility, which option is preferred?

Show the solution

Option A: U(9) = √9 = 3, so EU(A) = 3.
Option B: U(16) = 4 and U(4) = 2.
EU(B) = 0.5 × 4 + 0.5 × 2 = 2 + 1 = 3.
Both options have EU = 3, so the investor is indifferent.
Check the expected money value of B: 0.5 × 16 + 0.5 × 4 = ₹10 lakh, which is more than ₹9 lakh. The investor accepts ₹9 lakh as equal because of risk aversion.

Answer: The investor is indifferent, because both options have an expected utility of 3. The sure ₹9 lakh is the certainty equivalent of Option B, which has an expected value of ₹10 lakh.

Exam tips

Link each form to its information set first. Most EMH questions can be answered from that alone.
Watch for words like public, private, historical and insider. They tell you the form.
Expect questions that ask which statement is true about expected utility theory. Look for rational, risk-averse and final wealth.
For anomalies, know the names and the direction: January effect, small-firm effect, value effect, momentum.
In a negative-marking paper, skip an option set only when two choices stay equally likely after you apply the nesting rule.

Practice questions from Basics of Behavioural Finance

Traditional Finance and Efficient Market Hypothesis in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

Traditional Finance and Efficient Market Hypothesis: frequently asked questions

What are the three forms of the efficient market hypothesis?

The weak form says prices reflect all past price and volume data. The semi-strong form says they reflect all public information. The strong form says they reflect all public and private information.

Which form does insider trading profit contradict?

Consistent profit from insider information contradicts the strong form. The semi-strong and weak forms can still hold. This is why the strong form is seen as the hardest to defend.

How is expected utility theory different from prospect theory?

Expected utility theory assumes rational, risk-averse investors who judge final wealth. Prospect theory says people judge gains and losses from a reference point and feel losses more strongly than equal gains.

What are market anomalies?

They are patterns in returns that are hard to explain if markets are efficient. Examples are the January effect, small-firm effect, value effect and momentum. They are used to question EMH, though some can be explained by risk or costs.