Small company bias - Essay Example

The Small firm Effect and its relationship with EMH The efficient market hypothesis (EMH) also known as the Random walktheory (RWT) propose that the prevailing market prices of company stocks reflect the available market information about the value of a firm, and that no firm shall outperform or “beat the market” by getting abnormal profits. According to the theory of efficient market, it is highly unlikely that an individual can benefit from predicting the value of a company’s stocks base on historical movements of its prices (Edgar 34).

Traditionally, the efficient market hypothesis (EMH) has received general acceptance by most financial economists as reflecting the true and fair market condition about the stock prices. The EMH maintained that a market was perfect in the sense that the information spread very fast to accommodate immediate changes in the market stock prices. However, key criticisms have been leveled against this hypothesis based on a number of contradicting scenarios. The use of small firm effect has sustained the opposition and criticism for the EMH.

The extensive studies undertaken among the USA small firms indicated that small firms outperformed large firms in respect of stock prices in spite of their advantageous operational economies of capital and market dominance (Edgar 31-35). Investigators have found the strongest effect of the tendencies of small firms to generate large stock returns compared to returns on stocks of large companies. According to the survey carried out by Fanna and French (1992) on the stocks data between 1963 and 1990, they found that clearly, portfolios of small companies tended to produce higher monthly average returns that those made on stocks of large companies EMH (Jonathan, Jandik, and Mandelker, 17).

Therefore, it is essential to examine the EMH from a wide perspective that attempts to explore the necessary information. according to EMH, the larger the firm, the more advantageous it is in accessing and retaining important market information hence resulting in information asymmetry, hence creating an ability to benefit from the skewed information compared to the small firms. It should be noted that although the results of the studies of small fir effect have tended to degenerate the meaningfulness and application of EMH, it might harbor significant flaws such as survivor bias where the researcher might have used data from small firms that survived the informational imbalances (Edgar 34).

Since its inception about four decades ago, EMH has occupied a large space in economic literature. The researches on the EMH suggest that stock markets are generally efficient through illustrations on the evidences in favor of weak, semi-strong, and strong form of EMH (Jonathan, Jandik, and Mandelker, 16). Recent studies have tended to contradict previous studies that denied the effect of technical analysis in influencing the movement of stock prices on the market. Edgar (1996) reports the study by Baron (1992) that found out that simple grasp of technical rules in trading can successfully influence changes in stock prices in respect of Dow Jones Industrial Average (34).

Technical analysis involving the analysis of the company’s technical information reveals that the ability to utilize the profitability information of a firm would lead to profiting from the stock trading. However, evidences suggest that the proceeds gained remain insufficient in covering the underlying transaction costs. Subsequently, the succeeding results are in conformity with the evidences provided by the weak form version of EMH (Edgar 29-35).Works CitedClarke, Jonathan, Tomas, Jandik, and Gershom, Mandelker.

 “The Efficient Markets Hypothesis.” Web. 26 February 2012. < www.e-m-h.org/ClJM.pdf>.Edgar, Peters E. Chaos and order in the capital markets: a new view of cycles, prices, and market volatility. New York: John Wiley and Sons, 1996. Print.