Efficient Markets hyphotesis - Essay Example

Efficient Market Hypothesis Introduction In the 20th century, the financial markets all over the world developed at a great pace. This made even a common man able to invest in stock markets in hope of profits. This rapid development of financial markets started a debate on market efficiency, and whether or not people can earn consistent abnormal return for a considerable period of time. The concept of efficient market hypothesis is that prices of assets in the financial market cannot be discerned from historical pricing patterns as all the publicly available information is immediately reflected in the price of the assets (Fama, 1965). This simple concept has remarkable repercussions for the financial markets and investors alike. In this paper we will talk about the efficient market hypothesis in great detail with reference to technical and fundamental analysis. We will talk about market efficiency and types of market efficiencies. The concepts of ‘random walk’ and ‘fair game model’ will also be discussed. In the end test and studies conducted to prove the efficient market hypothesis will be presented alongside with the conclusion. The Efficient Market Hypothesis The efficient market hypothesis proposes that assets in financial markets are priced after taking all the public information available into account. This means that people might not be able to earn abnormal profit consistently for a long period of time. Efficient market hypothesis entails that investors cannot earn more than the average market returns by taking similar risk exposure as the market. This hypothesis therefore suggests that markets are efficient information wise and all the public information about an asset is perfectly reflected in the market. An obvious consequence of efficient market hypothesis, if accepted, is that markets always go towards equilibrium and this in turn means that financial markets are rational in general. Critics of efficient market hypothesis tend to dispute the ‘rationality of the markets’ as they feel that this hypothesis is not able to explain market crashes (Fox, 2009). If market is overall rational then all investors should immediately understand what’s going on in the market and bubbles might be avoided in the first place, according to critics of efficient market hypothesis. Market Efficiency Market efficiency is defined as a market in which in which prices always reflect all available information (Vaughan Williams, 2005). The concept of market efficiency is closely linked to the efficient market hypothesis. The idea behind market efficiency is to ensure that price changes quickly when new information comes and therefore giving no room for an investor to earn abnormal returns. This allows all the investors equal opportunity to earn money in the financial markets without giving anyone extra chance to gain profits on the basis on any skill or information. In an efficient market common investors and experts are alike. Types of Market Efficiency Market efficiency can be divided into three different forms, weak form, semi strong form, and strong form efficiency (Fama, 1970). These can be seen as level in which market can be seen as efficient starting from weak to strong form. The weak form efficiency states that securities price reflects all the past historic information and no one should be able to make abnormal profit based on past information. This form of efficiency ensures that no one is able to predict future pricing movements on the basis of historical prices because present prices are set taking into account all the information regarding the past prices. This form of efficiency ensures that investors are not able to make use of inefficiencies in the market in order to earn regular abnormal profits. Technical analysis will not work in weak form efficiency because it depends upon historical pricing patterns. This form of efficiency however does not say that prices will stay at equilibrium (or near it) at all times. There is room for earning abnormal returns, however, based on some fundamental analysis in weak form efficiency. Semi strong form of efficiency states that share prices reflects all public information and this means it would not be possible to make abnormal investment return based on public information which includes latest reports and news about the company. In this form of efficiency too technical analysis will be of no good for any investor because historical pricing patterns will not be able to predict future prices but in semi strong form efficiency even fundamental analysis will not work. Fundamental analysis relies on information about the asset and in this case all the information will be available to everyone in the market and prices will adjust readily as the information goes public. In this form of market efficiency one can earn abnormal return only on the basis of insider information that is not available to public. In the strong form of efficiency markets are perfectly efficient and even the insider information in reflected into the prices leaving no opportunity to earn abnormal returns (Pilbean, 2010). Fair Game Model- everybody knows the news- normal return Until this point we have established a theoretical foundation of efficient market hypothesis. Now we will attempt to build further on the topic of market efficiency by introducing the fair game model or the normal return model. This will be vital in proving that an efficient market is one in which abnormal profits cannot be made using publicly available information. The fair game model implies that one cannot expect to achieve any advantage whatsoever by using information of the previous events. Any previous knowledge of events that have been passed will not help an investor to predict future pricing patterns and therefore will eradicate any chance of making abnormal profits. This is where the name ‘fair game’ comes from because everyone in the market has the equal opportunity to make profits as there is no informational advantage enjoyed by anyone. This model also takes into account expectation of investors about the future events and concludes that investor expectation about the future is also translated into the pricing of financial assets (Jones & Netter, 2008). This means that price of an asset will only change in future when expectations of investors about that asset changes. The model also assumes that investor’s expectations are unbiased. Random Walk The random walk hypothesis states that prices of assets in the stock market fluctuate on a random basis and therefore they cannot be predicted accurately on a consistent basis by anyone. The pure randomness of stock market prices means that no one can predict the future price movements based on historical pricing patterns. This hypothesis is similar to efficient market hypothesis. The concept of ‘random walk’ was popularized by Malkiel in his book of 1973 ‘A random walk down Wall street’. He argued that anyone could earn profits in the stock market because stock price movements were strictly random. He also said that it was not useful to waste time in determining patterns in the stock market price. According to him an expert investment analysts and a blind folded chimpanzee throwing darts will perform similarly in the financial markets (Malkiel, 2011). This hypothesis, if accepted can shake the foundations of investment banking and stock trading. There are millions of analysts worldwide who daily try to beat the market and earn abnormal profits. Random walk hypothesis proves that all these people are wasting their time in trying to predict the future pricing movements. Technical Analysis and Markets Efficiency Technical analysis is the analysis of movement of historical prices in order to predict future price movements. It is a study of patterns and trends in the historical prices so that future prices can be predicted. Technical is based on the idea that history repeats itself and therefore a pattern identified will repeat itself in future as well. People all over the world use technical analysis to forecast future price movements in financial markets. Latest tools are available today that can help even novice investors to use technical analysis tools to perfection. It is obvious that technical analysis contradicts market efficiency because it relies on past information. Efficient market hypothesis states clearly that all public information is adjusted in the current price of an asset. This means that even if there are patterns in price movements they are readily identified by investors and due to competition no opportunity is left to earn abnormal profit on a regular basis. Technical analysis depends purely on historical data and therefore there is a contradiction between the two. Even in the weakest form of market efficiency historical prices are reflected in the current market prices and therefore no investor can make abnormal returns by keeping his risk similar to that of market. This is where technical analysis fails in the eyes of efficient market hypothesis. But supporters of technical analysis argue that it can help achieve consistent profits and one needs to have an eye to identify pricing patterns. It is true that the market crashes and market bubbles cannot be explained by efficient market hypothesis. If markets were efficient then people would have known immediately that a particular stock or group of stocks are a bubble and that would have busted the bubble immediately. But this did not happen and people lost huge amounts of money in the internet bubble of 1990s and many other stock market crashes. Fundamental Analysis and Efficient Market Hypothesis Fundamental analysis is another way to value the stock by observing the fundamental financial data of the company. It involves analyzing important news about the economy that can have an impact on the company. The aim of fundamental analysis is similar to that of technical analysis; to predict future price movements of financial assets. There are two strands of thought that criticize fundamental analysis. First school of thought constitutes of the proponents of efficient market hypothesis. According to the EMH all the public information about a stock is reflected in the price readily and therefore any fundamental information will already be reflected in the current price of the stock. The reliance of fundamental analysis on public information makes it contrary to the efficient market hypothesis. The second school of thought is against to fundamental analysis on grounds of lack of objectivity. It is argued that investors cannot accurately value any firm and therefore doing fundamental analysis is a waste of time. Example of Tests and Studies which have been done to prove the Theory “The weak form efficiency is easily proved, the strong form is impossible to prove, while the semi-strong form efficiency is the one around which most of the controversies hover” (Prodhan, 1986). Many tests and studies have been conducted in order to prove (or disprove) the efficient market hypothesis. The famous random walk test was conducted by Malkiel in which he attempted to prove the randomness of prices of financial assets. We can also conduct correlation tests to know whether weak form of efficiency holds true or not. Past share price return can be measured and can be compared with future price return. Studies that are centered on stock markets of the developing country show that there exists no evidence of even weak form efficiency in stock markets (Poshakwale, 1996). On technical analysis too studies have found evidence that it can yield substantial profits (Wong, Manzur, & Chew, 2010). Bubbles and stock market crashes also tend to question the validity of efficient market hypothesis. It is therefore not possible to conclude whether efficient market hypothesis is true or not because evidence exists on both the sides. Market is efficient with respect to information that cannot be used to earn abnormal profits consistently but the extent of market efficiency in financial markets is not easy to measure. Conclusion Efficient market hypothesis holds that financial markets are information wise efficient and all the publicly held information is reflected in the prices. This simple hypothesis can have significant repercussions for all investors because this would make price movements completely random and impossible to predict consistently. There are three forms of market efficiency namely weak form, semi strong form, and strong form of efficiency. The consequences of EMH are great on trading techniques like technical analysis and fundamental analysis. EMH proves both the analysis nothing but a waste of time. It is not possible to take sides on the issue of EMH as evidence exists on both sides. Bibliography Chew, B., Manzur, M., & Wong, W. (2010), How rewarding is technical analysis? Evidence from Singapore stock market, Applied Financial Economics, 13pp. 543-551. Fama, E. (1965), ‘The Behavior of Stock Market Prices’, Journal of Business, 38 pp. 34–105. Fama, E. (1970), ‘Efficient Capital Markets: A Review of Theory and Empirical Work’, Journal of Finance, 25 (2), pp. 383–417. Fox, J. (2009), ‘Myth of the Rational Market’, London: Harper Business. Jones, S. & Netter, J. (2008), Efficient Capital Markets, The Concise Encyclopedia of Economics. Accessed on April 16, 2012 from http://www.econlib.org/library/Enc/EfficientCapitalMarkets.html Malkiel, B. (2011), A Random Walk down Wall Street, 10th edition, New York: W.W. Norton & Company, Inc. Pilbean, K. (2010), Finance and Financial Markets, London: Palgrave Macmillan. Poshakwale, S. (1996), Evidence on Weak Form Efficiency and Day of the Week Effect in the Indian Stock Market, Finance India, 10 pp. 605-616. Prodhan, B. (1986), Multinational Accounting: Segment Disclosure and Risk, London: Routledge Kegan & Paul. Vaughan Williams, L. (2005), Information efficiency in financial and betting markets, Cambridge: Cambridge University Press. Read More