Rationality of the Capital Market: Capitalistic System vs. Islamic System

Abstract

Efficient Market Hypothesis (EMH) is founded on the theory of expected rationality but the theory of behavioural finance concludes that stock market investors are quasi-rational. Therefore, under the capitalistic system, the efficient markets have already failed to protect the rights of investors that have led to chronic capital market crashes and failure to achieve efficiency, justice, fairness, accountability, fair distribution of benefits, and a rational behaviour among investors. However, recently, Islamic financial institutions and markets have been emerging, which stand on the Shariah provision – the guided way to behave rationally or guided rationality. Based on the empirical experiences and evidences of both market systems, this paper discusses and compares the performances of the markets under the theoretical arguments of “rationality”, “quasi-rationality”, and “guided rationality”. This paper suggests that capital market based on guided rationality under the Islamic System can be a better alternative over the conventional market system.

Keywords: rational expectation; efficient market hypothesis; EMH; random walk model; behavioural finance; guided rationality; quasi-rationality; Islamic capital market; Islamic finance; Shariah; Mudaraba; sukuk; zakaah

JEL Classification: G11; P1; P47; P5