Efficient Market Hypothesis
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The efficient market hypothesis (EMH) posits that stock prices reflect all relevant information, making it impossible for investors to consistently beat the market through superior stock selection or timing. EMH has three forms: weak, semi-strong, and strong, each describing different levels of market efficiency regarding the availability and reaction to information. Critics argue that market inefficiencies exist and can be attributed to investor behavior, suggesting that while EMH remains a foundational theory, its application is contested in real-world scenarios.
![dealing with the momentum effect identified by Jegadeesh and Titman. Stocks that have
performed relatively well (poorly) over the past 3 to 12 months continue to do well (poorly) over
the next 3 to 12 months. The momentum strategy is long recent winners and shorts recent losers,
and produces positive risk-adjusted average returns. Being simply based on past stock returns,
the momentum effect produces strong evidence against weak-form market efficiency, and has
been observed in the stock returns of most countries, in industry returns, and in national equity
market indices. Moreover, Fama has accepted that momentum is the premier anomaly The
problem of algorithmically constructing prices which reflect all available information has been
studied extensively in the field of computer science. A novel approach for testing the weak form
of the Efficient Market Hypothesis is using quantifers derived from Information Theory. In this
line, Zunino et al.[30] found that informational efficiency is related to market size and the stage
of development of the economy. Using a similar technique, Bariviera et al. uncover the impact of
important economic events on informational efficiency. The methodology proposed by econo
physicists Zunino, Bariviera and coauthors is new and alternative to usual econometric
techniques, and is able to detect changes in the stochastic and or chaotic underlying dynamics of
prices time series.
2. Semi-strong-form efficiency
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. Semi-strong- form efficiency implies that neither fundamental
analysis nor technical analysis techniques will be able to reliably produce excess returns. To test
for semi-strong-form efficiency, the adjustments to previously unknown news must be of a
reasonable size and must be instantaneous. To test for this, consistent upward or downward
adjustments after the initial change must be looked for. 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.](https://image.slidesharecdn.com/finnce-190216073316/85/Efficient-Market-Hypothesis-6-320.jpg)
Efficient Market Hypothesis
- 1. Efficient Market Hypothesis In financial economics, the efficient-market hypothesis (EMH) states that it is impossible to beat the market because stock market efficiency causes existing share prices to always incorporate and reflect all relevant information. According to the EMH, stocks always trade at their fair value on stock exchanges, making it impossible for investors to either purchase undervalued stocks or sell stocks for inflated prices. As such, it should be impossible to outperform the overall market through expert stock selection or market timing, and that the only way an investor can possibly obtain higher returns is by purchasing riskier investments. The following are the main assumptions for a market to be efficient: r of investors analyze and value securities for profit. in a random fashion. Financial theories are subjective. In other words, there are no proven laws in finance, but rather ideas that try to explain how the market works. There are three major versions of the hypothesis: weak; semi-strong, and strong. The weak form of the EMH claims that prices on traded assets (e.g., stocks, bonds, or property) already reflect all past publicly available information. The semi-strong form of the EMH claims both that prices reflect all publicly available information and that prices instantly change to reflect new public information. The strong form of the EMH additionally claims that prices instantly reflect even hidden or insider information. Critics have blamed the belief in rational markets for much of the late-2000s financial crisis. In response, proponents of the hypothesis have stated that market efficiency does not mean having no uncertainty about the future, that market efficiency is a simplification of the world which may not always hold true, and that the market is practically efficient for investment purposes for most individuals.
- 2. Joint hypothesis problem The joint hypothesis problem says that it is never possible to test (sufficiently, to prove or disprove) market efficiency. A test of market efficiency must include some model for how prices may be set efficiently. Then actual prices can be examined to see whether this holds true. Usually this fails and then this supports the case that markets are not efficient. The joint hypothesis problem says that, when this happens, it shows that the model is not complete. There are some factors that are not accounted for. Going further, such factors must have a rational basis, because that is the assumption. No one needs to explain what these factors might be (in fact that is dangerous because it can be proved wrong), just that they may exist, or no one can prove that they don’t. Historical background Possible origins Historically, there is a very close link between EMH and the random walk hypothesis and then the Martingale model. The random character of stock market prices was first modeled in 1863 by Jules Regnault, a French broker. Later, it was modeled in 1900 by a French mathematician, Louis Bachelier, in his 1900 PhD thesis, The Theory of Speculation. His work was largely ignored until the 1950s; however, beginning in the 1930s scattered, independent work corroborated his thesis. A small number of studies indicated that US stock prices and related financial series followed a random walk model Research by Alfred Cowles in the ’30s and ’40s suggested that professional investors were in general unable to outperform the market.
- 3. Initial formulation 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. thesis in the early 1960s. It was widely accepted up until the 1990s, when behavioral finance economists, who had been a fringe element, became mainstream. Empirical analyses have consistently found problems with the efficient-market hypothesis, the most consistent being that stocks with low price to earnings (and similarly, low price to cash-flow or book value) outperform other stocks. Alternative theories have proposed that cognitive biases cause these inefficiencies, leading investors to purchase overpriced growth stocks rather than value stocks. Although the efficient- market hypothesis has become controversial because substantial and lasting inefficiencies are observed, Beechey et al. (2000) consider that it remains a worthwhile starting point. Impacts The efficient-market hypothesis emerged as a prominent theory in the mid-1960s. Paul Samuelson had begun to circulate Bachelie’s work among economists. In 1964 Bachelier’s dissertation along with the empirical studies mentioned above were published in an anthology edited by Paul Cootner. In 1965, Eugene Fama published his dissertation arguing for the random walk hypothesis. Also, Samuelson published a proof showing that if the market is efficient prices will show random-walk behavior. This is often cited in support of the efficient-market theory, by the method of affirming the consequent, however in that same paper, Samuelson warns against such backward reasoning, saying From a nonempirical base of axioms you never get empirical results. In 1970, Fama published a review of both the theory and the evidence for the hypothesis. The paper extended and refined the theory, included the definitions for three forms of financial market efficiency: weak, semi-strong and strong. It has been argued that the stock market is “micro efficient” but not “macro efficient”. The main proponent of this view was Samuelson,
- 4. who asserted that the EMH is much better suited for individual stocks than it is for the aggregate stock market. Research based on regression and scatter diagrams has strongly supported Samuelson’s dictum. This result is also the theoretical justification for the forecasting of broad economic trends, which is provided by a variety of groups including non-profit groups as well as by for-profit private institutions (such as brokerage houses and consulting companies).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. A study by Khan of the grain futures market indicated semi-strong form efficiency following the release of large trader position information (Khan,1986). 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. 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. 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. 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. Theoreticalbackground Beyond the normal utility maximizing agents, the efficient-market hypothesis requires that agents have rational expectations; that on average the population are correct (even if no one person is) and whenever new relevant information appears, the agents update their expectations appropriately. Note that it is not required that the agents be rational. EMH allows that when faced with new information, some investors may overreact and some may under react. 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). Thus,
- 5. any one person can be wrong about the market—indeed, everyone can be—but the market as a whole is always right. There are three common forms in which the efficient-market hypothesis is commonly stated— 1. Weak-form efficiency, 2. Semi-strong- form efficiency and 3. Strong-form efficiency each of which has different implications for how markets work. 1. Weak-formefficiency In weak-form efficiency, future prices cannot be predicted by analyzing prices from the past. Excess returns cannot be earned in the long run by using investment strategies based on historical share prices or other historical data. Technical analysis techniques will not be able to consistently produce excess returns, though some forms of fundamental analysis may still provide excess returns. Share prices exhibit no serial dependencies, meaning that there are no patterns to asset prices. This implies that future price movements are determined entirely by information not contained in the price series. Hence, prices must follow a random walk. 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. 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 and that, moreover, there is a positive correlation between degree of trending and length of time period studied (but note that over long time periods, the trending is sinusoidal in appearance). Various explanations for such large and apparently non- random price movements have been promulgated. There is a vast literature in academic finance
- 6. dealing with the momentum effect identified by Jegadeesh and Titman. Stocks that have performed relatively well (poorly) over the past 3 to 12 months continue to do well (poorly) over the next 3 to 12 months. The momentum strategy is long recent winners and shorts recent losers, and produces positive risk-adjusted average returns. Being simply based on past stock returns, the momentum effect produces strong evidence against weak-form market efficiency, and has been observed in the stock returns of most countries, in industry returns, and in national equity market indices. Moreover, Fama has accepted that momentum is the premier anomaly The problem of algorithmically constructing prices which reflect all available information has been studied extensively in the field of computer science. A novel approach for testing the weak form of the Efficient Market Hypothesis is using quantifers derived from Information Theory. In this line, Zunino et al.[30] found that informational efficiency is related to market size and the stage of development of the economy. Using a similar technique, Bariviera et al. uncover the impact of important economic events on informational efficiency. The methodology proposed by econo physicists Zunino, Bariviera and coauthors is new and alternative to usual econometric techniques, and is able to detect changes in the stochastic and or chaotic underlying dynamics of prices time series. 2. Semi-strong-form efficiency 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. Semi-strong- form efficiency implies that neither fundamental analysis nor technical analysis techniques will be able to reliably produce excess returns. To test for semi-strong-form efficiency, the adjustments to previously unknown news must be of a reasonable size and must be instantaneous. To test for this, consistent upward or downward adjustments after the initial change must be looked for. 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.
- 7. 3. Strong-form efficiency In strong-form efficiency, share prices reflect all information, public and private, and no one can earn excess returns. 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. To test for strong-form efficiency, a market needs to exist where investors cannot consistently earn excess returns over a long period of time. 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.