Efficient Market Hypothesis - Essay Example

Efficient Market Hypothesis Abstract This study deals with one of the most important areas of behavioural finance, the efficient market hypothesis. Objective of this study is to critically examine different forms of efficient market efficiency, especially the weak or semi-weak form. There are empirical theories and models developed on this critical financial issue. Important theories like random walk hypothesis, fair game model have been discussed in this paper. Different forms of efficient hypothesis, i.e. weak, semi-strong and strong, will be critically analyzed to identify why different forms of market efficiency lead to major issue in fundamental analysis of companies. Implications of weak or semi strong market efficiency will be discussed with evidence. Lastly, arguments on efficient market efficiency will be addressed on behaviour finance perspective. Introduction Efficiency in market means that there is absence of any systematic way to beat the market. The efficient market hypothesis states that the information about the value of the firm is fully reflected in the current stock prices. It also states that the firm will not be able to earn to excess profits i.e. profits over and above the profits made by the other players in the market by using this information. The hypothesis deals with two of the fundamental questions of finance behaviour. The first of them is why there is price change in the market for securities while the second considers how the change actually occurs. Investors involve themselves in identifying the securities that are expected to witness an increase in their current value of investment in the future. Moreover, they always try to identify those securities which will witness the maximum increase in their value. They are of the opinion that they have the capability to select only those securities that are expected to perform unexpectedly well in the market and drive the others out. In the process they use different forecasting techniques as well as some valuation methods. The combination of the techniques helps them in their decisions regarding investments. However, the hypothesis states that the techniques are not effective and no one has the capability to predict the outperformance of the market. If the investors enjoy any advantage, it is supposed not to exceed the incurred cost of transaction and research (Timmermann, & Granger, 2003, p.5). Literature review The origin of efficient market hypothesis can be traced back in the studies of two individuals in 1950s. One is Paul A. Samuelson and the other one is Eugene F. Fama. They identified the notion of market efficiency from two different research agendas. Samuelsson’s contribution in the invention of EMH was great, and the researcher summarized that in efficient market, changes in asset (stocks, bonds and other traded instruments) price can be forecasted if these are properly anticipated. This means price should fully incorporate all the information and expectation of all the market participants. In contrast to Samuelsson, Fama concentrated on statistical measures of stock price and resolving the debate regarding technical analysis and fundamental analysis of stock price. This researcher summarized that current price stocks fully reflect all information available to market participants. These two empirical research studies on this critical area of finance have helped many researchers thereafter to develop several econometric single or multifactor linear asset pricing models (Seweel, 2011, p.4). Random walk hypothesis Importance of efficient market hypothesis can be identified from empirical implications of it in many pieces of research and studies by empirical researchers. Literature on efficient market hypothesis before LeRoy (1973) and Lucas (1978) was evolved around the random walk hypothesis and magnitude model. These are statistical description of price changes that can be forecasted and initially taken to be implication efficient market hypothesis. The first test of random walk hypothesis was developed by Jones and Cowles (1973), and they compared frequency sequence and reversal in historical return of stocks. They identified same sign of former pairs of consecutive return and the opposite sign of latter pair of consecutive return. Osborne (1959), Fama (1963; 1965), Cootner (1962; 1964), Fama and Blume (1966) conducted tests of random walk hypothesis and supported previous studies of random walk hypothesis using historical stock return. Lo and McKinley (1988) reported that variance of two week stock return is double the variance of one week stock return. They conducted this test on US indexes from 1962 to 1985. French and Roll (1985) identified from their study that variance of stock return over weekends and holidays are much lower than variance of week days, especially first three weekdays of a week. Poterba and Summers (1988) and Fama and French (1988) found out negative correlation in US stocks indexes return from stock return data of 1962 to 1986. The correlation coefficient from their study was large in magnitude due to insufficient data to reject random walk hypothesis at its level of significance. A number of statistical studies on random walk hypothesis were conducted by Startz, Nelson and Kim (1991) and Richardson (1993), but they conclude major doubts on reliability longer horizon interfaces of random walk hypothesis. Finally, Lo (1991) conducted long term memory of RWH to indentify and uncover sort of short term correlation by the researcher at initial stage (Dimson & Mussavian, 2000, p.2). Fair game model Earlier studies and tests on the efficient market hypothesis were conducted based on therandom walk hypothesis, which concluded that stock price return changes randomly and does not follow any time specification. Next stages of studies and tests on the efficient market hypothesis were conducted based on the fair game model. Fama (1970) conducted studies on the efficient market hypothesis based on the fair game model. Main requirement of this model is that process of price formation need to be very specified in detailed information so that to identify the actual meaning of “fully reflect.” Available models of price equilibrium formulate prices in terms of rate of return that is highly depended risk associated with return of stocks. Such theories of expected return of stocks can be described as follows. This is fair game model, and the equitation represents that expected stock price is equal to time of current stock price plus expected return on the specific security if full set is required and relevant information is available. The fair game model should consider all current and past values of relevant market information, i.e. interest rate, gross domestic product, rate of earnings etc of a specific country of sample stocks. It is also assumed that model includes relevant relationship among these variables (Malkiel, 2001, p .384). Efficient market hypothesis Efficient market hypothesis suggests that it is extremely difficult to profit by predicting the movements in the prices. If in a market, the prices can adjust quickly without being biased to new information, such a market is called efficient market. The availability of new information can lead to change in prices. The available information is reflected in the current prices of the securities taking a period under consideration. Adjustment in the price level takes place before an investor has sufficient time to trade and accrues profit from new information. Competition among the investors to accrue profit is one of the foremost reasons for the existence of efficient markets. Many are also involved in identifying the stocks that are mispriced. When more and more investment advisors or the market analysts spend time on taking the advantage from the stocks that are either lowly priced or highly priced, the probability of detecting the securities that are mispriced becomes smaller. In a situation characterized by equilibrium, only a small number of analysts will be able to gain from the mix-priced securities because of the chance factor. All investments performing in the market are priced fairly. But it does not imply that they will perform in similar fashion because of the effect of rise or fall in the price level. The capital market theory states that the return expected from a security is a function of the risk. As the nature of the new information is unpredictable, the changes in the prices are expected to be random, and the prices of the stocks follow the random walk theory. Analysis Three forms of market efficiency There are three versions of the hypothesis, namely, the weak form, the semi-strong form and the strong form of hypothesis. The weak form of efficiency states that the information about the history of prices only is incorporated in the current prices, and that is why nobody can detect the securities that are mispriced and gain from the gain by analyzing the prices of the past, though it is assumed that current market price of stocks correctly represents past trading volume and other information contained in past price record. The semi-strong form of the hypothesis states that the current price reflects not only past performance but all the information that is currently available to the public because the market rapidly adapts to the new information of its constituents, i.e. financial information related to individual stocks. The last form of hypothesis, that is the strong form, asserts that the weak and the semi-strong forms of market efficiency and market prices not only represent all past and present information correctly but also correctly forecast or predict the future information. The strong form of efficiency also claims that current market prices can instantly reflect any insider or hidden information about a particular stock. These three forms assume uniform and linear cost of credit for all investors. These also assume that cost of transaction and information asymmetry does not exist. Critics of efficient market hypothesis blamed investors’ belief in rational market for the core reason behind late 2000s financial crisis. But the proponents of the efficient market hypothesis stated that market efficiency does not say about zero uncertainty in future prediction or forecasted return. It is a simplification form of risk adjusted return prediction. Therefore, financial market has become efficient platform for investment by both individuals and institutions. Market efficiency as a fundamental issue The aim of all investors is to accrue maximum gains. The newly generated techniques to predict the movements in price have not been as successful as expected. If the risks and the costs of transaction are taken into account, then active management of security is a losing proposition. Although there is no such theory that can be called efficient from all perspectives, yet the empirical evidence supports the hypothesis under consideration. There are some opponents who are against the hypothesis, but the evidence they provide is not strong enough to undervalue the propositions of the hypothesis. The serial correlations in the short run supported the view that the market for stocks does not possess a very good memory (Clarke, Jandik, & Mandelker, n.d. p.12). Some of the findings show that the correlations are not zero, and the successive movement in the same direction leads to the rejection of the hypothesis. There is a tendency that the investors will under-react to the newly available information. If the effects of the information are found for a period of time, then the prices of the stocks will witness a positive correlation. The implications of the hypothesis is of concern as the fundamental analysis reveals the fact that analysis of historical data is of no help as the information is already incorporated in the prices of the assets. The assumption of the hypothesis is that the participants of the market at the forecast are of rational expectation. This implies that the participants of the market have similar expectations on the returns of future securities. Implications of weak or semi-strong market efficiency The pieces of research all direct mainly to one fundamental conclusion. Fully efficient markets are not possible logically and can be regarded as a myth. Since it is not possible for the market to operate at the full efficiency level, the estimates of the damages based on the efficient market hypothesis and the analyses after the movement in the prices of the stocks will frequently overestimate the damages, and the estimation will be significant. The hypothesis only takes into consideration the situations where the decline in the large stocks can be observed, and in this kind of situation, there can be exaggeration of small emerging inefficiencies. The market should not be deemed to be efficient for the purpose of estimating the damages. The efficient market hypothesis ignores how to use the information variables to generate the actual estimates. However, one can change the definition of the efficiency in the market to cover up this aspect. The continuous profit seeking behaviour of the investors can generate efficient type of markets. But the hypothesis does not rule out the existence of many other variables that are not deemed for the strategy of profit seeking. If the weak form of the efficient market hypothesis is studied, it can be observed that the historical movements in prices are of no utility in order to predict the future price movements under this form. The magnitude or the direction of the price movements will be of no help, either. The semi-strong form of hypothesis asserts that all the publicly available information is of no help to predict the future movements in price. Thus, this form contradicts the concept or the proposition proposed by the fundamental analysts. Instead of calling the market perfectly efficient, the market can be regarded as reasonably efficient mainly for two reasons. Firstly, if the markets are deemed to be non-efficient, then it would not been possible to study the market portfolio theory. The anomalies in the market for stocks can be explained by the behavioural biases as well as the imperfections in the institutions (Malkiel, 2003, p.61). EMH on behaviour finance perspective The fundamental analysts of investment use the factors which are thought of as fundamental to the organization. Such kind of analysts may have the inclination to recommend purchase decisions, or the company operates in the sector which the analyst believes will witness the brighter side in the near future. But the technical analysts think that the fundamental factors are completely reflected in the behaviour of the stock in the market. Therefore, all data are internal to the company, and the prediction of the movement of the stock prices is possible by examining the past prices of the stocks. Therefore, recent changes in volume as well as changes in the prices might influence the analyst to recommend the purchase decisions. The analysts are slightly uncomfortable to deal with the hypothesis, and they are of the opinion that the hypothesis is far from the reality (The Economist, 2009). Conclusion The criticism of the hypothesis are similar to those of the theories of the long run equilibrium, which focuses mainly on the outcomes at the equilibrium and does not consider the activity of the entrepreneur that forms the basis to generate the outcomes. The propositions of the efficient market hypothesis assert that there is difference between investing capital in the stocks and investing the capital in business. The success or the failure of the investment that were made in stocks will ultimately depend on the same factors that pave the way for the success or the failure of the business activity. The statistical tests which are responsible to test the validity of the hypothesis are based on the methods that are full of flaws, and the validation of the theory is at stake. Bibliography Clarke, J., Jandik, T. and Mandelker, G. n.d. The Efficient Markets Hypothesis. [pdf]. Available at: [Accessed on November 21, 2012]. Dimson, E. & Mussavian, M. 2000. MARKET EFFICIENCY. [pdf]. Available at: [Accessed on November 21, 2012]. Malkiel, B.G. 2003. The Efficient Market Hypothesis and Its Critics. [pdf]. Available at: [Accessed on November 21, 2012]. Malkiel, B.G., 2001. Stock Market Price Behaviour. [pdf]. Available at: [Accessed on November 21, 2012]. Seweel, M., 2011. History of the Efficient Market Hypothesis. [pdf]. Available at: . [Accessed on November 21, 2012]. The Economist, 2009. Efficiency and beyond. [online]. Available at: [Accessed on November 21, 2012]. Timmermann, A. & Granger, C.W.J., 2003. Efficient market hypothesis and forecasting. [pdf]. Available at: [Accessed on November 21, 2012]. Read More