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 therefore are unbiased in the sense that they reflect the collective beliefs of all investors about future
prospects. Professor Eugene Fama at the University of Chicago Graduate School of Business developed EMH as an
academic concept of study through his published Ph.D. thesis in the early 1960s at the same school.
The efficient market hypothesis states that it is not possible 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.
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.[1] Also, work by Cowles in the 30s and 40s showed that
professional investors were in general unable to out perform 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 [2]. In 1965, Eugene Fama published his dissertation[3] arguing for the random walk hypothesis and Samuelson published
a proof for a version of the efficient market hypothesis[4]. 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)[5].
Theoretic 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 (which is different from rational expectations; rational agents act
coldly and achieve what they set out to do). 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
- No excess returns can be earned by using investment strategies based on historical share prices or other financial data.
- Weak-form efficiency implies that Technical analysis techniques will not be able
to consistently produce excess returns, though some forms of fundamental analysis
may still provide excess returns.
- In a weak-form efficient market current share prices are the best, unbiased, estimate of the value of the security.
Theoretical in nature, weak form efficiency advocates assert that fundamental analysis can be used to identify stocks that are
undervalued and overvalued. Therefore, keen investors looking for profitable companies can earn profits by researching financial
statements.
Semi-strong form efficiency
- Share prices adjust within an arbitrarily small but finite amount of time and in an unbiased fashion to publicly available
new information, so that no excess returns can be earned by trading on that information.
- Semi-strong form efficiency implies that Fundamental analysis techniques will
not 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.
Strong-form efficiency
- Share prices reflect all information 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. Studies on the U.S. stock market have shown that people do
trade on inside information.[citation needed]
- 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 tens of thousands of fund managers worldwide[citation needed], even a normal distribution of returns (as efficiency predicts) should be
expected to produce a few dozen "star" performers.
Arguments concerning the validity of the hypothesis
Some observers dispute the notion that markets behave consistently with the efficient market hypothesis, especially in its
stronger forms. Some economists, mathematicians and market practitioners cannot believe that man-made markets are strong-form
efficient when there are prima facie reasons for inefficiency including the slow
diffusion of information, the relatively great power of some market participants (e.g. financial institutions), and the existence
of apparently sophisticated professional investors. The way that markets react to surprising news is perhaps the most visible
flaw in the efficient market hypothesis. For example, news events such as surprise interest rate changes from central banks are
not instantaneously taken account of in stock prices, but rather cause sustained movement of prices over periods from hours to
months.
Only a privileged few may have prior knowledge of laws about to be enacted, new pricing controls set by pseudo-government
agencies such as the Federal Reserve banks, and judicial decisions that effect a
wide range of economic parties. The public must treat these as random variables, but
actors on such inside information can correct the market, but usually in a discreet manner to avoid detection.
Another observed discrepancy between the theory and real markets is that at market extremes what fundamentalists might
consider irrational behaviour is the norm: in the late stages of a bull market, the market is driven by buyers who take little
notice of underlying value. Towards the end of a crash, markets go into free fall as participants extricate themselves from
positions regardless of the unusually good value that their positions represent. This is indicated by the large differences in
the valuation of stocks compared to fundamentals (such as forward price to earnings ratios) in
bull markets compared to bear markets. A theorist
might say that rational (and hence, presumably, powerful) participants should always immediately take advantage of the
artificially high or artificially low prices caused by the irrational participants by taking opposing positions, but this is
observably not, in general, enough to prevent bubbles and crashes developing. It may be inferred that many rational participants are aware of the irrationality
of the market at extremes and are willing to allow irrational participants to drive the market as far as they will, and only take
advantage of the prices when they have more than merely fundamental reasons that the market will return towards fair value.
Behavioural finance explains that when entering positions market participants are not
driven primarily by whether prices are cheap or expensive, but by whether they expect them to rise or fall. To ignore this can be
hazardous: Alan Greenspan warned of "irrational
exuberance" in the markets in 1996, but some traders who sold short new economy
stocks that seemed to be greatly overpriced around this time had to accept serious losses as prices reached even more
extraordinary levels. As John Maynard Keynes succinctly commented, "Markets can remain irrational
longer than you can remain solvent."[citation needed]
The efficient market hypothesis was introduced in the late 1960s. Prior to that, the prevailing view was that markets were
inefficient. Inefficiency was commonly believed to exist e.g. in the United States and
United Kingdom stock markets. However, earlier work by Kendall (1953) suggested that
changes in UK stock market prices were random. Later work by Brealey and Dryden, and also by Cunningham found that there were no
significant dependences in price changes suggesting that the UK stock market was weak-form efficient.
Further to this evidence that the UK stock market is weak form efficient, other studies of capital markets have pointed toward
them 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 cannot necessarily be taken as indicative of a market efficient at pricing regarding more long term and amorphous
factors however.
Other empirical evidence in support of the EMH comes from studies showing that the return of market averages exceeds the
return of actively managed mutual funds. Thus, to the extent that markets are inefficient, the benefits realized by seizing upon
the inefficiencies are outweighed by the internal fund costs involved in finding them, acting upon them, advertising etc. These
findings gave inspiration to the formation of passively managed index funds.[6]
It may be that professional and other market participants who have discovered reliable trading rules or stratagems see no
reason to divulge them to academic researchers. It might be that there is an information gap between the academics who study the
markets and the professionals who work in them. Some observers point to seemingly inefficient features of the markets that can be
exploited e.g seasonal tendencies and divergent returns to assets with various
characteristics. E.g. factor analysis and studies of returns to different types of investment strategies suggest that some types
of stocks may outperform the market long-term (e.g in the UK, the USA and Japan).
Skeptics of EMH argue that there exists a small number of investors who have outperformed the market over long periods of
time, in a way which is difficult to attribute luck, including Peter Lynch, Warren Buffett, George Soros, and Bill Miller. These investors' strategies are to a large extent based on identifying markets where
prices do not accurately reflect the available information, in direct contradiction to the efficient market hypothesis which
explicitly implies that no such opportunities exist. Among the skeptics is Warren Buffett who has argued that the EMH is not correct, on one
occasion wryly saying "I'd be a bum on the street with a tin cup if the markets were always efficient"[citation needed] and on another saying "The
professors who taught Efficient Market Theory said that someone throwing darts at the stock tables could select stock portfolio
having prospects just as good as one selected by the brightest, most hard-working securities analyst. Observing correctly that
the market was frequently efficient, they went on to conclude incorrectly that it was always efficient."[citation needed] Adherents to a stronger form of the
EMH argue that the hypothesis does not preclude - indeed it predicts - the existence of unusually successful investors or funds
occurring through chance.
It is important to note, however, that the efficient market hypothesis does not account for the empirical fact that the most
successful stock market participants share similar stock picking policies, which would seem indicate a high positive correlation
between stock picking policy and investment success. [citation needed]For example, Warren Buffett, Peter Lynch, and George Soros all made their
fortunes exploiting differences between market valuations and underlying economic conditions. This notion is further supported by
the fact that all stock market operators who regularly appear in the Forbes 400 list made their fortunes working as full time
businesspeople, most of whom received college educations and adhered to a strict stock picking philosophy they developed at a
relatively early age. If "throwing darts at the financial pages" were as effective an approach to investment as deliberate
financial analysis, one would expect to see casual, part time investors appearing in rich lists as frequently as professionals
like George Soros and Warren Buffett.
The efficient market hypothesis also appears to be inconsistent with many events in stock market history. For example, the
stock market crash of 1987 saw the S&P 500 drop more than 20% in the Month of October despite the fact that no major news or
events occurred prior to the Monday of the crash, the decline seeming to have come from nowhere. This would tend to indicate that
rather irrational behaviour can sweep stock markets at random.
The EMH and popular culture
Despite the best efforts of EMH proponents such as Burton Malkiel, whose book
A Random Walk Down Wall Street (ISBN 0-393-32535-0) 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." The theme was further explored in the recent The Little Book That Beats The
Market (ISBN 0-471-73306-7) by Joel Greenblatt.
One notable exception to this trend is the recent book Wall Street Versus America (ISBN 1-59184-094-5), by
investigative journalist Gary Weiss. In this caustic attack on Wall Street practices, Weiss
argues in favor of the EMH and against stock-picking as an investor self-defense mechanism.
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 of that performance that can be made with publicly available information.
That estimate may still be grossly wrong without violating EMH.
An alternative theory: Behavioral Finance
-
Opponents of the EMH sometimes cite examples of market movements that seem inexplicable in terms of conventional theories of
stock price determination, for example the stock market crash of October 1987 where
most stock exchanges crashed at the same time. It is virtually impossible to explain the scale of those market falls by reference
to any news event at the time. The explanation may lie either in the mechanics of the exchanges (e.g. no safety nets to
discontinue trading initiated by program sellers) or the peculiarities of human nature.
Behavioural 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). A growing field of research called behavioral finance studies how cognitive or emotional biases, which are individual or collective,
create anomalies in market prices and returns that may be inexplicable via EMH alone. However, how and if individual biases
manifest inefficiencies in market-wide prices is still an open question. Indeed, the Nobel Laureate co-founder of the programme -
Daniel Kahneman - announced his skepticism of resultant inefficiencies: "They're
[investors] just not going to do it [beat the market]. It's just not going to happen."[7]
Ironically, the behaviorial finance programme can also be used to tangentially support the EMH - or rather it can explain the
skepticism drawn by EMH - in that it helps to explain the human tendency to find and exploit patterns in data even where none
exist. Some relevant examples of the Cognitive biases highlighted by the programme are:
the Hindsight Bias; the Clustering illusion;
the Overconfidence effect; the Observer-expectancy effect; the Gambler's fallacy;
and the Illusion of control.
See also
References
- ^ See Working (1934), Cowles and Jones (1937), and Kendall (1953)
- ^ Cootner (ed.), Paul (1964).
The Random Character of StockMarket Prices. MIT Press.
- ^ Fama, Eugene (1965). "The Behavior of Stock
Market Prices". Journal of Business 38: 34-105.
- ^ Paul, Samuelson (1965). "Proof That
Properly Anticipated Prices Fluctuate Randomly". Industrial Management Review 6: 41-49.
- ^ Fama, Eugene (1970). "Efficient Capital
Markets: A Review of Theory and Empirical Work". Journal of Finance 25: 383-417.
- ^ Bogle, John C. (2004-04-13). As The Index Fund Moves from Heresy to Dogma . . . What More Do We Need To Know?. The Gary M. Brinson
Distinguished Lecture. Bogle Financial Center. Retrieved on 2007-02-20.
- ^ Hebner, Mark (2005-08-12). Step 2: Nobel Laureates. Index Funds: The 12-Step Program for Active Investors. Index Funds Advisors, Inc..
Retrieved on 2005-08-12.
- Burton G. Malkiel (1987). "efficient market hypothesis," The New Palgrave: A Dictionary of Economics, v. 2, pp. 120-23.
- Cowles, Alfred; H. Jones (1937). "Some A Posteriori Probabilitis in Stock Market Action".
Econometrica 5: 280-294.
- Kendall, Maurice. "The Analysis of Economic Time Series". Journal of the Royal Statistical
Society 96: 11-25.
- Paul Samuelson, "Proof That Properly Anticipated Prices Fluctuate Randomly." Industrial Management Review, Vol. 6, No. 2, pp.
41-49. Reproduced as Chapter 198 in Samuelson, Collected Scientific Papers, Volume III, Cambridge, M.I.T. Press, 1972.
- Working, Holbrook (1960). "Note on the Correlation of First Differences of Averages in a
Random Chain". Econometrica 28: 916-918.
External links
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