WikiPortallus: Efficient market.html

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. The efficient-market hypothesis states that it is impossible to consistently outperform the market by using any information that the market already knows, except through luck. 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.

The EMH 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 at the same school. It was widely accepted up until the 1990s, when behavioral finance economists, who were a fringe element, became mainstream.¹ Empirical analyses have consistently found problems with the efficient markets 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.²³ Alternative theories have proposed that cognitive biases cause these inefficiencies, leading investors to purchase overpriced growth stocks rather than value stocks.¹ Although the efficient markets hypothesis has become controversial because substantial and lasting inefficiencies are observed, it remains a worthwhile starting point.⁴

Historical background

The efficient-market hypothesis was first expressed by Louis Bachelier, a French mathematician, in his 1900 dissertation, "The Theory of Speculation". His work was largely ignored until the 1950s; however beginning in the 30s 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.⁵ 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 theoretic position in the mid-1960s. Paul Samuelson had begun to circulate Bachelier's work among economists. In 1964 Bachelier's dissertation along with the empirical studies mentioned above were published in an anthology edited by Paul Coonter.⁶ In 1965 Eugene Fama published his dissertation arguing for the random walk hypothesis,⁷ and Samuelson published a proof for a version of the efficient-market hypothesis.⁸ 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 market efficiency: weak, semi-strong and strong (see below).⁹

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. 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. The market's ability to efficiently respond to a short term and widely publicized event such as a takeover announcement, however, cannot necessarily be taken as indicative of a market efficient at pricing regarding more long term and 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. 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.¹⁰

Theoretical background

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.

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 underreact. 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, 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 — weak-form efficiency, semi-strong-form efficiency and strong-form efficiency, each of which have different implications for how markets work.

Weak-form efficiency

Semi-strong-form efficiency

Strong-form efficiency

Criticism and behavioral finance

Price-Earnings ratios as a predictor of twenty-year returns based upon the plot by Robert Shiller (Figure 10.1,¹¹ source). The horizontal axis shows the real price-earnings ratio of the S&P Composite Stock Price Index as computed in Irrational Exuberance (inflation adjusted price divided by the prior ten-year mean of inflation-adjusted earnings). The vertical axis shows the geometric average real annual return on investing in the S&P Composite Stock Price Index, reinvesting dividends, and selling twenty years later. Data from different twenty year periods is color-coded as shown in the key. See also ten-year returns. Shiller states that this plot "confirms that long-term investors—investors who commit their money to an investment for ten full years—did do well when prices were low relative to earnings at the beginning of the ten years. Long-term investors would be well advised, individually, to lower their exposure to the stock market when it is high, as it has been recently, and get into the market when it is low."¹¹ This correlation between price to earnings ratios and long-term returns is not explained by the efficient-market hypothesis.

Investors and researchers have disputed the efficient markets hypothesis empirically and theoretically. Behavioral economists attribute the imperfections in financial markets to a combination of cognitive biases such as overconfidence, overreaction, representative bias, information bias, an inability to use configural rather linear reasoning, and various other predictable human errors in reasoning and information processing. These have been researched by psychologists such as Daniel Kahneman, Amos Tversky, Richard Thaler, and Paul Slovic. 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 markets hypothesis³ ² low P/E stocks have greater returns. In this paper he also refuted the assertion by Ray Ball that these higher returns could be attributed to higher beta,¹² whose research had been accepted by efficient market theorists as explaining the anomaly¹³^:151 in neat accordance with modern portfolio theory.

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. These bubbles are typically followed by an overreaction of frantic selling, allowing shrewd investors to buy stocks at bargain prices. 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.

Another anomaly exists in the form of the investors who beat the market soundly on a long-term basis, including Peter Lynch, Warren Buffett, George Soros, and John Templeton. Warren Buffett has commented that "I'd be a bum on the street with a tin cup if the markets were always efficient".

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.¹⁴

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). But Nobel Laureate co-founder of the programme—Daniel Kahneman—announced his skepticism of investors beating the market: "They're [investors] just not going to do it [beat the market]. It's just not going to happen."¹⁵ Richard Thaler has started a fund based on his research on cognitive biases. In a 2008 report he identified complexity and the herd behavior as central to the global financial crisis of 2008.¹⁶

Popular reception

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. Popular books and articles promoting various forms of stock-picking, such as the books by popular CNBC commentator Jim Cramer and former Fidelity Investments fund manager Peter Lynch, have continued to press the more appealing notion that investors can "beat the market."

EMH is commonly rejected by the general public due to a misconception concerning its meaning. 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. In other words, they believe that EMH says a stock's price correctly predicts the underlying company's future results. 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. 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. Whether that information turns out to have been correct is not something required by EMH. 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. 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 to those willing to incur the cost of acquiring the valuable information in order to trade on it. Tests to return predictability have shown this to be a factor which has been used to make the highlight the existence of an efficient market. Additionally the concept of liquidity is a critical component to capturing "inefficiencies" in tests for abnormal returns. Despite a stronger case being evident for an efficient market, 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. Thus how can one know if the market is efficient if the one does not know if their model correctly stipulates the required rate of return. Consequently, a situation arises where either the asset pricing model is incorrect or the market is inefficient, but one cannot know both answers at the same time.

Efficient market.html

Contents