Efficient Market Hypothesis - Essay Example

Efficient Market Hypothesis Part I Efficient market is a term that attempts to clarify the correlation between stock prices and information availablein the capital market (Malkiel 2003, p.2). The idea of an efficient market hypothesis dates back to 1953 when it was first introduced by Maurice Kendall. It is reported that Kendall was interested in discovering the behavior of share prices and commodities in the market. It is from the study that he concluded that share prices are independent of each other. This was followed by Samuelson’s (1965) concept of Efficient Market Hypothesis (EMH) that predicted that stock prices fluctuate randomly. However, it was later, in 1970, that Fama reviewed the concept of market efficiency by categorizing market efficiency into three forms, which includes weak form, semi-strong form, and strong form (Malkiel 2003, p.2-4). Weak form Fama (1970) argues that a market becomes efficient in its weak form when the past returns cannot be used for predicting the stock price changes in the market. This implies that stock returns are serially independent and have a constant mean (Malkiel 2003, p.2-4). Technically this implies that no investor has the power to influence the direction of share prices for their advantage based on past price patterns. This is because the prevailing stock prices are absolutely a reflection of information available in past prices. In addition, the stock prices reflected under the weak form of the efficient market is at a point where the marginal revenue derived from acting on the information is less than the marginal cost. Strong form Fama (1970) concluded that a market becomes efficient in its strong form when stock prices in the market are a true reflection of new information available in the market. This implies that investors have the power to use the information available to their advantage and earn abnormal profits. This takes us to the concept of insider trading in which managements may take advantage of private information in a company to make investments decisions that are likely to enable them make abnormal or supernormal profits. The information may include those pertaining to rights issue. In addition, in a strong form of efficient market, investors are always assured that the prices of the stocks they purchased are fairly priced. This implies that investors cannot be overcharged for the stocks they intend to purchase in the market. Semi-strong Fama (1970) argues that a market becomes efficient in its semi-strong form when the prices of stock reflect new information available in public instantly. This implies that stock prices can neither be undervalued nor overvalued. As such, no trading activity in the market can influence the prices of stock to result in better returns. This also shows that even speculations cannot influence the prices in such a market. Part II The efficient market hypothesis (EMH) is a concept that holds that stock prices in the market reflect fully all the available information (Lo 2007, p.1). Nevertheless, the concept has generated many controversies from many economies and psychologists, who argue that the concept is on unrealistic assumptions regarding rationality. This part of the paper will examine the concept of efficient market hypotheses. The concept is mainly based on RWH hypothesis states that any subsequent price change reflects a random departure from the previous prices (Odean 1999, p. 1279-1282). This is to say that if information is leaked into the market and happens to be reflected in stock prices immediately, subsequent price changes would also mirror the news of that particular day, which would be independent of the current price fluctuations. It is true that news is unpredictable, as one may not know what the next day holds with regard to news. This implies that prices would reflect only the information that exists in the public domain at any given time (Keim 1983, p.13-15). The hypothesis also holds that regardless of whether or not an investor has enough information, they are able to receive a generous rate of return similar to those received by experts in the market. The theory is, therefore, favorable since it does not favor speculation in the market, which only tends to benefit those with first hand information. For instance, if a market is inefficient, it implies that those with first hand information are able to capitulate on stock price information to earn good returns. This would certainly encourage much speculation in the market and insider trading as a means of benefiting a few people who have information regarding the stock prices (Ariel 1990, p.71-77). Augments against EMH Research indicates that investors are never reactive to proper proportion to new information in the market. This in itself is seen as a departure from the theory of EMH (Rasches 2001, p. 1911-1927). This is because, in some cases, an investor may be forced to overreact to stocks performance, by selling off shares that had experienced losses in the past. Others overreact to buying stocks that have had received considerable gains in the past in the hope that the stocks would be in high demand, in the market. Such reactions tend to increase the demand of stocks in question thereby pushing the prices of stock beyond their market value (Debondt and Thaler 1995, p.793-796). This in most cases would prompt rational investors to react in the reverse direction so as to lower the prices back to their fair value. When such a situation occurs, what results is a price reversal, which implies that everything that goes up must come down (Kahneman and Mark 1998, p.52-56). Such a scenario will also result in a contrarian investment plan where losers are bought and winners sold, resulting in better income. Data taken from the US stock market recent has shown such implications. Data revealed that losers and winners in a month’s period have the habit of reversing their performance over the same duration in subsequent periods. The concept of EMH is also being criticized based on anomalies, a consistent pattern in the returns of an asset, which is reliable, inexplicable and well known. In this regard, it is noted that regularity and reliability of the pattern implies that it is highly predictable, which goes against the concept of EMH. In addition, since the regularity is widely known is a clear indication that many investors are can take advantage of it. This has being evident among small-capitalization corporations whose stocks sometimes accrue excess returns compared to the risk as noted by Cooper, Dimitrov and Rau (2001, p.16-19). This implies the degree to which investors can influence the stock prices in the market. Impossibility of efficient markets Some economists argue that there cannot be a market that is perfectly efficient informational. Therefore, such an argument is a fallacy, arguing that if a market were perfect, there would be no benefit in trying to gather information pertaining to the market. This would also render trade meaningless leading to a collapse of the markets. This is certainly true because many investors try to gather information regarding the market because of its inefficiency. This means that if it were perfect, then investors would not find it meaningful spending much of their time trying to gather information regarding market. As a result, an equilibrium point would only be achieved in the market where there are no enough opportunities for profit to reimburse investors for expenses incurred on information collection and trade (Fluck, Malkiel and Quadndt 1997, 177-179). The argument proposed by semi-strong form of market efficiency that stock prices in the market can neither be undervalued or overvalued is not true. Going by evidence, there are several instances where stock prices may end up being undervalued because of information available in the market. For instance, stock prices tend to go down when there is bad information regarding the stock in question. This is because since investors are risk averse, they tend to sell off their stock when they have information that stocks may incur losses. This usually makes prices of such stock be undervalued in the market, thus a departure from the concept of EMH. On the other hand, investors would most likely rush to purchase stock whose value is expected to appreciate in the near future. When such a scenario occurs, demand for the stock would most likely push up leading to overvaluation of the stock in question, which also indicates a deviation from the EMH concept (Campbell, Lo and MacKinlay 1997, p.13-17). Behavioral critic The EMH has also received considerer able criticism based on behaviors and preferences of market players. Research indicates that many investors are always risk averse. This implies that they are unwilling to take high risks always, especially where the returns may not be proportional to the risk. Nevertheless, economists and psychologies have departed from this argument on behavioral biases basis. In this regard, they argue that the fact that investors become risk averse in times of gains and take risks only when losses are eminent is not prudent since it leads to poor financial decisions. This is likely to prove unfavorable to the investor (Hawawini and Keim 1995, p.497-499). Conclusion In reality, no market can be absolutely efficient or inefficient. As such, the market should be considered broadly as a conglomerate of both, taking note that daily events may not always mirrored instantly into a market. For a market to be efficient, certainly no investor would be seeking for abnormal returns, which is ultimately the main motive for every investor. References Ariel, R.A. (1990), “High stock returns before holidays: Existence and evidence of possible causes,” Journal of finance, 45(5), December 1611-1626. Campbell, J.Y., Lo, A.W., & MacKinlay, A.C. 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(2007), Efficient market hypothesis. New York, NY: Palgrave McMillan. Malkiel, B.G. (2003), Efficient market hypothesis and its critics. Princeton University, No. 91. Odean, T. (1999), “Do investors trade too much?” American Economic Review, 89, 1279-1298. Rasches, M (2001), “Massively confused investors making conspicuously ignorant choices (MCI-MCIC), Journal of Finance, 56:5, 1911-1927. Read More