Essay on The Efficient Market Hypothesis
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The efficient market, as one of the pillars of neoclassical finance, asserts that financial markets are efficient on information. The efficient market hypothesis suggests that there is no trading system based on currently available information that could be expected to generate excess risk-adjusted returns consistently as this information is already reflected in current prices. However, EMH has been the most controversial subject of research in the fields of financial economics during the last 40 years. “Behavioural finance, however, is now seriously challenging this premise by arguing that people are clearly not rational” (Ross, (2002)). Behavioral finance uses facts from psychology and other human sciences in order to…show more content…
The weak-form efficiency cannot explain January effect. In semi-strong-form efficient market, to test this hypothesis, researchers look at the adjustment of share prices to public announcements such as earnings and dividend announcements, splits, takeovers and repurchases. As time goes, later tests tend to be not supportive to EMH. For instance, semi-strong-form efficiency cannot explain the pricing/earning effect. In strong-form efficiency, the highest level of market efficiency, Fama (1991) pointed out the immeasurability of market efficiency and suggested that it must be tested jointly with an equilibrium model of expected. However, perfect efficiency is an unrealistic benchmark that is unlikely to hold in practice.
Last but not least important, an efficient capital market is one in which stock prices fully reflect all available information. However, the paradox is that since information is reflected in security prices quickly, knowing information when it is released does an investor little good. Furthermore, it is impossible to create a portfolio which would earn extraordinary risk adjusted return. As a consequence, all the technical and fundamental analysis are useless, no one can consistently outperform the market, and new
The efficient market hypothesis (EMH) was promoted by Eugene Fama in the
A capital market is said to be efficient to if it fully and correctly reflects all relevant information in determining security prices. Therefore, more formally, the market is efficient with respect to some information set. ..if security prices would be unaffected by revealing that information to all participants. Moreover, efficiency implies that it is impossible to make economic profits by trading on the basis of the defined information set (Papers4you.com, 2006).
As it follows from the Malkiel (1992) definition if the market is efficient the company market value should be an unbiased estimate of the true value. Nevertheless it is important to stress that:
1. Market efficiency does not require that market price is equal to the true value
2. There is an equal probability that stocks over or under valued at any point in the time
3. And finally, investors should not be able to consistently identify under or over valued stocks using any investment strategy ( Damodaran, 2006).
What are the implications of the market efficiency from the individual investor perspective?
Firstly, equity research is costly and provides no benefits. Secondly strategies that have minimal execution costs such as randomly diversified portfolio or indexing to the market would be superior to any other investment strategy. Thirdly, a strategy that has minimum transaction costs should provide higher returns in the long run (Damodaran, 2006).
Nevertheless it is important to stress that markets are not efficient due to their nature, but they are driven to efficiency by the actions of the investors. Therefore Roberts(1967) distinguished among three forms of the market efficiency:
1. Weak form: the information set includes only historic data.
2. Semi strong: the information set includes publicly available information.
3. Strong form: the information set includes all information know to any market participant and includes private information.
Obviously in reality, investors have access to different information sets. While trading which is based on the insider information is prosecuted, analysis and interpretation of the publicly available information requires specific knowledge and skills (Papers4you.com, 2006). Therefore the efficient market should be seen as a self correcting mechanism, where inefficiencies appear at regular intervals but disappear almost instantaneously as investors find and trade on them.
EMH has wide applications in the financial markets, since it is easily extended to the valuation of companies , market failures such as an Enron Case, or performance analysis of the mutual funds. The traditional analysis of the market efficiency is based on the analysis of the anomalies such as Peso Effect in the foreign exchange market or devoted to the predictability of the stock returns.
Damodaran )nline (2006) “MARKET EFFICIENCY - DEFINITION AND TESTS”, Available from: http://pages.stern.nyu.edu/~ADAMODAR/ New_Home_Page/invemgmt/effdefn.htm [17/06/2006]
Fama E. F., 1970, Efficient capitalmarkets: Areviewof theory and empiricalwork, Journal of Finance, 25, 383–417.
Malkiel B (1992) Efficient market hypothesis. In NewMan P.M. Milgate ,and J Eawells (eds). The new Palgrave dictionary of Money and Finance.
Papers For You (2006) "C/F/94. Validity of the Efficient Market Hypothesis", Available from [17/06/2006]
Papers For You (2006) "E/F/38. Efficient market hypothesis: theory and implications", Available from [18/06/2006]
Robersts, H. 1967. Statistical versus clinical predictions of the stock markets. Unpublished manuscript, Center for research in Security Prices, , May.