Efficient market hypothesis

Research by Alfred Cowles in the ’30s and ’40s suggested that professional investors were in general unable to outperform the market. The efficient-market hypothesis emerged as a prominent theory in the mid-1960s. Even if some money managers are consistently observed to beat the market, no refutation even of strong-form efficiency follows: with hundreds of thousands of fund managers worldwide, even a normal distribution of returns (as efficiency predicts) should be expected to produce a few dozen star performers. Investors and researchers have disputed the efficient-market hypothesis both empirically and theoretically.

There are three common forms in which the efficient-market hypothesis is commonly stated — weak-form efficiency, semi-strong-form efficiency and strong-form efficiency, each of which has different implications for how markets work. In weak-form efficiency, future prices cannot be predicted by analyzing price from the past. To test for this, consistent upward or downward adjustments after the initial change must be looked for.

To test for semi-strong-form efficiency, the adjustments to previously unknown news must be of a reasonable size and must be instantaneous. Rather, it says that a stock s price represents an aggregation of the probabilities of all future outcomes for the company, based on the best information available at the time.

However, the market s ability to efficiently respond to a short term, widely publicized event such as a takeover announcement does not necessarily prove market efficiency related to other more long term, amorphous factors. It was widely accepted up until the 1990s, when behavioral finance economists, who were a fringe element, became mainstream. The efficient-market hypothesis was first expressed by Louis Bachelier, a French mathematician, in his 1900 dissertation, The Theory of Speculation .

Technical analysis techniques will not be able to consistently produce excess returns, though some forms of fundamental analysis may still provide excess returns. To test for strong-form efficiency, a market needs to exist where investors cannot consistently earn excess returns over a long period of time.

This implies that future price movements are determined entirely by information not contained in the price series. His work was largely ignored until the 1950s; however beginning in the 30s scattered, independent work corroborated his thesis.

Paul Samuelson had begun to circulate Bachelier s work among economists. However, while EMH predicts that all price movement (in the absence of change in fundamental information) is random (i.e., non-trending), many studies have shown a marked tendency for the stock markets to trend over time periods of weeks or longer In semi-strong-form efficiency, it is implied that share prices adjust to publicly available new information very rapidly and in an unbiased fashion, such that no excess returns can be earned by trading on that information.

But Nobel Laureate co-founder of the programme—Daniel Kahneman—announced his skepticism of investors beating the market: They re The recent global financial crisis has led to renewed scrutiny and criticism of the hypothesis. At the International Organization of Securities Commissions annual conference, held in June 2009, the hypothesis took center stage. These errors in reasoning lead most investors to avoid high-value stocks and buy growth stocks at expensive prices, which allow those who reason correctly to profit from bargains in neglected value stocks and the overreacted selling of growth stocks. Empirical evidence has been mixed, but has generally not supported strong forms of the efficient-market hypothesis in neat accordance with modern portfolio theory. One can identify losers as stocks that have had poor returns over some number of past years.

If there are legal barriers to private information becoming public, as with insider trading laws, strong-form efficiency is impossible, except in the case where the laws are universally ignored. Therefore, according to theory, it is impossible to consistently outperform the market by using any information that the market already knows, except through luck.

Paul McCulley, managing director of PIMCO, was less extreme in his criticism, saying that the hypothesis had not failed, but was seriously flawed in its neglect of human nature. Despite the best efforts of EMH proponents such as Burton Malkiel, whose book A Random Walk Down Wall Street achieved best-seller status, the EMH has not caught the public s imagination. This tendency of returns to reverse over long horizons (i.e., losers become winners) is yet another contradiction of EMH.

Consequently, a situation arises where either the asset pricing model is incorrect or the market is inefficient, but one has no way of knowing which is the case. The critical work on random walk was done in the late 1980s by Profs. Rational investors have difficulty profiting by shorting irrational bubbles because, as John Maynard Keynes commented, Markets can remain irrational longer than you can remain solvent. Sudden market crashes as happened on Black Monday in 1987 are mysterious from the perspective of efficient markets, but allowed as a rare statistical event under the Weak-form of EMH. Burton Malkiel, a well-known proponent of the general validity of EMH, has warned that certain emerging markets such as China are not empirically efficient; that the Shanghai and Shenzhen markets, unlike markets in United States, exhibit considerable serial correlation (price trends), non-random walk, and evidence of manipulation. Behavioral psychology approaches to stock market trading are among some of the more promising alternatives to EMH (and some investment strategies seek to exploit exactly such inefficiencies).

Additionally the concept of liquidity is a critical component to capturing inefficiencies in tests for abnormal returns. The 2007 bear market could be cited as evidence.

Since stock prices clearly do not reflect company future results in many cases, many people reject EMH as clearly wrong. However, EMH makes no such statement. Andrew Lo and Craig MacKinlay; they effectively argue that a random walk does not exist, nor ever has.

thesis in the early 1960s at the same school. Thus, any one person can be wrong about the market — indeed, everyone can be — but the market as a whole is always right.

A study on stocks response to dividend cuts or increases over three years found that after an announcement of a dividend cut, stocks underperformed the market by 15.3% for the three-year period, while stocks outperformed 24.8% for the three years afterward after a dividend increase announcement. Beyond the normal utility maximizing agents, the efficient-market hypothesis requires that agents have rational expectations; that on average the population is correct (even if no one person is) and whenever new relevant information appears, the agents update their expectations appropriately. Studies by Firth (1976, 1979, and 1980) in the United Kingdom have compared the share prices existing after a takeover announcement with the bid offer.

For while the use of very sophisticated models of the market was able to accrue profits from the existence of small anomalies in the market since their general adoption by hedge funds, brokers and investment banks early in this century, the current downturn has seemingly stymied all of these models and, moreover, has wiped out such profits going back over a dozen years. Note that it is not required that the agents be rational.

Hence, prices must follow a random walk. Losers would have to have much higher betas than winners in order to justify the return difference.

These bubbles are typically followed by an overreaction of frantic selling, allowing shrewd investors to buy stocks at bargain prices. Various forms of stock picking, such as active management, are promoted by popular CNBC commentator Jim Cramer and former Fidelity Investments fund manager Peter Lynch, whose books and articles have popularised the notion that investors can beat the market . Many believe that EMH says that a security s price is a correct representation of the value of that business, as calculated by what the business s future returns will actually be.

All that is required by the EMH is that investors reactions be random and follow a normal distribution pattern so that the net effect on market prices cannot be reliably exploited to make an abnormal profit, especially when considering transaction costs (including commissions and spreads). A small number of studies indicated that US stock prices and related financial series followed a random walk model.

The study showed that the beta difference required to save the EMH is just not there. Speculative economic bubbles are an obvious anomaly, in that the market often appears to be driven by buyers operating on irrational exuberance, who take little notice of underlying value. This soft EMH does not require that prices remain at or near equilibrium, but only that market participants not be able to systematically profit from market inefficiencies .

The hypothesis has been attacked lately by critics who blame belief in rational markets for much of the current financial crisis, The efficient-market hypothesis was developed by Professor Eugene Fama at the University of Chicago Booth School of Business as an academic concept of study through his published Ph.D. If there are any such adjustments it would suggest that investors had interpreted the information in a biased fashion and hence in an inefficient manner. In strong-form efficiency, share prices reflect all information, public and private, and no one can earn excess returns.

Firth found that the share prices were fully and instantaneously adjusted to their correct levels, thus concluding that the UK stock market was semi-strong-form efficient. Martin Wolf, the chief economics commentator for the Financial Times, dismissed the hypothesis as being a useful way to examine how markets function in reality.

Their paper took almost two years to be accepted by academia and in 2001 they published A Non-random Walk Down Wall St. which explained the paper in layman s terms. . EMH allows that when faced with new information, some investors may overreact and some may underreact.

Put another way, EMH does not require a stock s price to reflect a company s future performance, just the best possible estimate or forecast of future performance that can be made with publicly available information. Share prices exhibit no serial dependencies, meaning that there are no patterns to asset prices.

Information or news in the EMH is defined as anything that may affect prices that is unknowable in the present and thus appears randomly in the future. Fixed income Corporate bond Government bond Municipal bond Bond valuation High-yield debt Stock Preferred stock Common stock Registered share Voting share Stock exchange Credit derivative Hybrid security Options Futures Forwards Swaps Commodity market Money market OTC market Real estate market Spot market Finance series Financial market Financial market participants Corporate finance Personal finance Public finance Banks and Banking Financial regulation In finance, the efficient-market hypothesis (EMH) asserts that financial markets are informationally efficient , or that prices on traded assets (e.g., stocks, bonds, or property) already reflect all known information, and instantly change to reflect new information.

Winners would be those stocks that had high returns over a similar period. The main result of one such study is that losers have much higher average returns than winners over the following period of the same number of years.

These have been researched by psychologists such as Daniel Kahneman, Amos Tversky, Richard Thaler, and Paul Slovic. In 1964 Bachelier s dissertation along with the empirical studies mentioned above were published in an anthology edited by Paul Cootner. Further to this evidence that the UK stock market is weak-form efficient, other studies of capital markets have pointed toward their being semi-strong-form efficient.

Excess returns can not be earned in the long run by using investment strategies based on historical share prices or other historical data. Any test of this proposition faces the joint hypothesis problem, where it is impossible to ever test for market efficiency, since to do so requires the use of a measuring stick against which abnormal returns are compared - one cannot know if the market is efficient if one does not know if a model correctly stipulates the required rate of return.

In other words, they believe that EMH says a stock s price correctly predicts the underlying company s future results. That estimate may still be grossly wrong without violating EMH. Further empirical work has since highlighted the impact transaction costs have on the concept of market efficiency, with much evidence suggesting that any anomalies pertaining to market inefficiencies are the result of a cost benefit analysis made by those willing to incur the cost of acquiring the valuable information in order to trade on it.

David Dreman has criticized the evidence provided by this instant efficient response, pointing out that an immediate response is not necessarily efficient, and that the long-term performance of the stock in response to certain movements are better indications. Behavioral economists attribute the imperfections in financial markets to a combination of cognitive biases such as overconfidence, overreaction, representative bias, information bias, and various other predictable human errors in reasoning and information processing.

Semi-strong-form efficiency implies that neither fundamental analysis nor technical analysis techniques will be able to reliably produce excess returns. Whether that information turns out to have been correct is not something required by EMH.