Market efficiency is a subject of great debate among financial economists. The traditional approach holds that markets are efficient, whereas proponents of behavioral finance hold that in special circumstances market prices tend to be inefficient.

The debate about market efficiency has centered on a series of anomalies, such as the winner–loser effect, short-term momentum, post-earnings-announcement drift, stock split drift, and the new-issues puzzle. The traditional approach contends that these phenomena can be explained by compensation for risk. Proponents of behavioral finance suggest that these phenomena reflect market mispricing.

The notion of arbitrage is central to the debate between proponents of market efficiency and proponents of behavioral finance. Traditionalists contend that the actions of arbitrageurs render price inefficiencies small and temporary. Behaviorists contend that arbitrage is limited and that as a result market prices can deviate from intrinsic values substantially and for long periods of time.

Managers appear to behave as if they believe markets are inefficient. For example, they indicate that they would reject positive NPV projects if accepting those projects would lower their firm’s EPS. They split their stocks, even though doing so has no value when markets are efficient. And they time IPOs to take advantage of hot issue markets.

Behavioral explanations alone do not explain managerial behavior in respect to IPOs. Agency issues also contribute to explaining initial underpricing and long-term underperformance, two other IPO phenomena.