Efficient Market Hypothesis (EMH), also known as Random Walk Theory, has been subject of discussion, especially among economists for the past 50 years. At the same time, it has been one of the topics that have received rigorous research among scholars since it was first formulated. EMH is also one of the fundamental theories that explain the movement of asset prices. Its main assumption, therefore, is that markets operate efficiently and stock prices reflect all the information available. However, the big question is whether markets operate efficiently. Therefore, the main aim of this paper is to discuss the main ideas behind EMH and give one event that raises doubt about EMH.
Overview of EMH
EMH is an investment theory, which states that it is not possible to beat the market mainly because market efficiency makes existing share prices to always incorporate and reflect all relevant information that is available in the market. Based on the principle of the theory, stocks always trade at their fair value, making hard for investors buy undervalued stock or inflated stocks (Clarke, Jandik & Mandelker, 2001). Therefore, according to EMH, it is not possible to outperform the general market by undertaking expert stock selections or through market timing. Hence, in order to investors to obtain higher returns, they must be willing and ready to purchase riskier investments. Proponents of EMH argue that it is difficult and unlikely to predict price movements in a market. According to them, the main driving force behind price changes is the arrival of new information. The ability of investors to identify both undervalued and overvalued priced stock is important in the market, and it largely depends on the availability of new information. According to economist Eugene Fama, the person behind EMH, stiff competition among investors is what makes the market efficient.
Therefore, the main assumptions of EMH are that available information is universally shared among investors, and stock prices follow random walk, which means that prices are determined by the most current news or information, and not previous events (Clarke, Jandik & Mandelker, 2001). However, the strengths of the assumptions rely on whether EMH is strong, semi-strong or weak. Hence, there are three forms of EMH that include weak form efficiency,
Weak form efficiency is based on the assumption that the current stock prices completely incorporate information contained in the previous history of prices alone. It means that no investor is able to detect mis-priced stocks and beat the market by critically evaluating past prices. The concept of weak form efficiency is found on the fact that stock prices are publicly available, and investors cannot benefit by using information that is available for the public, including other investors.
Semi-strong form efficiency, on the other hand, suggests that current stock price completely incorporates all the information that is available for public consumption (Clarke, Jandik & Mandelker, 2001). The information does not only include past prices, but also data contained in a firm’s financial statements, all information about competitors, and predictions regarding macroeconomic factors like employment and fluctuation in prices. The assumption behind this form of EMH is that it is possible for a person to benefits from information that is publicly available. However, in order to benefit from information that is publicly available; an investor must have adequate financial expertise and knowledge and be in a position to access crucial financial information. Hence, according to EMH, only economists and financial experts, including highly experienced investors are able to have additional benefit to publicly available information in the security market. However, semi-strong form is the most controversial type of EMH, and it has attracted the most attention. This is mainly because of its assumption that investors are not able to consistently profit by trading on the information that is publicly available. Nevertheless, there is a general belief that investors have the ability to beat the market consistently.
Unlike weak and semi form efficiencies, strong form efficiency assumes that current stock prices incorporates all existing information, which include both private and public information. Strong form efficiency is different from semi-strong efficiency in that, in the former, no investor should be able to systematically come up with profits, even if the available information is not publicly known at the time of making profit (Clarke, Jandik & Mandelker, 2001). For instance, an investor is not able to systematically gain from private information by buying shares ten minutes after he decides to pursue what he believes to be more profitable, but not known by others investors in the market. The main rationale behind the strong form efficiency is that the market fairly anticipates future developments. As result, there are three form of EMH, which differ based on the amount information that is available to investors in the stock market.
The EMH is advantageous, especially to managers of commercial firms, as it discourage them from relying on market perception. It encourages such managers to pay more attention in managing operative assets where they can get the most comparative advantage, instead of spending much of their time and resources managing market perceptions. Consequently, managers and investors are able to make rational decisions that can make them to gain in the stock market.
Problems with EMH
The main problems associated with EMH are based on its assumptions. First, under EMH, it is assumed that all investors understand and perceive available information in the same manner. However, the availability of different methods that can be used to analyze stock in the market challenges the assumption. For instance, some of the investors only focus on the undervalued market opportunities while others evaluate stocks based on the growth potential. Therefore, there is high possibility that the two investors using different methods to arrive at different assessment of stocks, and perceive the available information in different ways. As a result, since different investors evaluate stocks in different ways, their perceptions will be different. Consequently, it is rare to confirm or ascertain what a stock should be worth under an efficient market.
Another assumption by EMH no investor is able to gain greater profitability than others with the same amount of funds invested is also problematic and not realistic. According to the theory, with the same amount of information available to all investors, they are only able to achieve the same return. However, practically, this is not possible because investors always have wide range of investment returns. For instance, there is always a range of yearly returns in the mutual fund mutual industry despite the availability of the same information. In addition, EMH assumes that if a single investor is profitable, then all investors have gained profit. Nevertheless, there are investors in the mutual fund industry who make profits while others are making losses at any given time. In addition, according to EMH, no investor has the ability to beat the market. But there are a number of examples that have proved that investors are able to beat the market. Hence, some of the assumption of EMH are not realistic and can easily be challenged.
Some of the experienced investors such as George Soros and Warren Buffet are effectively able to beat the market. Constant arrival of new information always makes prices to fluctuate. As a result, it is possible for an investor benefit if the new information causes stock prices owned by an investor to substantially increase. Even though an investor cannot consistently outperform the market, some can do it for a long time. Therefore, the assumption that an investor cannot beat the market can be challenged.
It is also not logical to assume that the new information fully reflects the market prices. The market always experience price fluctuation, which is an indication that it is not efficient. New information significantly affects values of stocks, leading to constant adjustments and fluctuations. An investor does not need to be financial expert or an economist in order to benefit from the arrival of new information. Not all investors follow the securities they trade in the market.
Apart from the above problems, the theory also has a lot of shortcomings, as it has fall short of its application since it was formulated around 50 years ago. Like other financial theories, EMH also fall short of practical perspective on the market. The major concern question is why the market is still experiencing bubbles when it is efficient. The theory has failed to explain the market anomalies such as speculative bubbles and extreme volatility. For instance, in 2008-2009 financial crises, many established companies lost value in their stock due to fear and panic. Speculative bubbles that dominate stock market come about as a result of inefficiency in pricing of individual stocks, including the market as a whole. Contrary to the expectation that investors always make rational decisions, they always make irrational decisions as they are looking towards to gain from arbitrage opportunities. During the financial crisis, EMH failed to adjust stock prices to rational level. Therefore, market bubbles come about because market is always inefficient and tendency of investors to make irrational decisions.
Limitations of EMH
Like any other theory, EMH also has limitations. One of the main limitations associated with EMH is that it is a pure exchange model of information that is available in the market, especially security market. It does not give any information about the supply side of the market, as it only concentrates on the demand side of the market (Ball, 2009). For instance, it does not tell how much information is available to investors. At the same time, the theory does not mention the source of the information such as the financial statements and government statistics. Therefore, the theory is not holistic, as it does not provide all information about the market.
EMH also models information as an objective commodity that can be used in a similar ways by investors. However, in reality, investors deduce different meanings from the available market information because they have different values, beliefs, and perceptions about information. Besides, the actions of investors are not only influenced by the available information, but behaviors of other investors in the market (Ball, 2009). In addition, EMH also assumes that information processing is costless, which is not true. Even though it seems that the cost of acquiring information is negligible, it is expensive to process available information. For instance, a company may be forced to employ highly skilled economists to synthesize stock price information. In addition, the theory assumed that there is continuous transaction in the market, and it ignores the liquidity effects. Therefore, EMH also has some limitations that limit its applicability in the real world situation.
Events Showing Concern Against EMH
Although there are a lot of evidence supporting EMH, it has not received uniform acceptance from some of the scholars, as they have been able to use events taking place in the world to show that market is not efficient. A good number of investment professional still look at EMH with a lot of concern and skepticism. Some of the ardent critics of the theory such as Michael Price are certain that market cannot be perfectly efficient. EMH has also been accused of causing a number of financial crises such as the 2008-2009 financial crises that led to economic instability in almost all parts of the world.
A number of empirical studies have been used to discredit the notion that market is efficient. One of the main assumptions of the EMH is that investors respond quickly and in unbiased ways to the arrival of new information in the market. However, according to empirical research that was conducted by Debondt and Thaler, the assumption is not true. The two researchers found out that securities with low long-term previous returns always have higher future returns. At the same time, they revealed that any stock with high long-term previous returns have low future returns. The findings of the researcher contradict the assumption that has been held by the proponents of EMH for a long time. Such like empirical studies can be used to confirm that indeed the market is not efficient.
Apart from empirical evidence, there are anomalies that have occurred in the security market that prove that market is indeed inefficient. One good example is January Effect where stock prices take abnormal rise over a relatively long period of time between December and January. Interestingly, price changes during the period are more significant in small companies, which are in contrary to random walk behavior of the EMH. There is also evidence that market always overact to emergence of new information. For instance, in the case that a company announces large changes in its earnings, there will be overreaction on stock prices, which will normalize after a few weeks. Therefore, it is possible for investors to gain abnormal returns when they strategically invest at the right time, even it is not supported by the proponents of the theory. A number of events can be used to illustrate the concerns raised against EMH.
2008-2009 financial crisis is one of the event that raise concern about EMH. A number of scholars have argued that EMH was the primary cause of the crisis. Under EMH, it is not possible for market bubbles to exist. One of the key proponents of the EMH, Fama, has plainly denied that market bubbles exist. However, even though people like Fama denied that market bubbles exists, market strategist such as Jeremy Grantham believe that market bubbles exist and they were the reasons behind the global financial crisis that was felt by the whole world between 2008 and early 2009 (Courtois, 2009). According to Grantham, EMH was the sole cause of the crisis because it led to the underestimation of the risks of assets bubbles. The same argument was supported by Justin Fox, especially through his bestselling book known as The Myth of the Rational Market.
According to the EMH, participants in the financial market act as powerful information collectors about true value of stock prices based on the available information (Ball, 2009). However, the big question is why investors got it wrong as far as housing and security markets are concerned. Housing prices increased substantially and securities were sold at prices that did not reflect their true risks. Strong belief in efficient financial market deceived investors, including experienced economists. The fact that every investors was gaining from housing and security markets made them to believe that prices would continue to rise indefinitely. Unfortunately, the markets were experiencing financial bubble, but due to the hard behavior made investors in both markets to overlook risks that were linked to security and mortgage during the time. Consequently, they excessively invest on housing and securities, which led to global financial crisis.
Therefore, it is not true that all information available in the market is reflected in prices as claimed by supporters of EMH. Investors and policy makers did not see the possibility that that markets have gotten the prices wrong. The idea that prices are right as held by proponents of EMH is not always wrong, as they can be influenced by other factors. With the efficient market rationale, investors dismissed the argument that surging prices in housing and security market was wrong, as they believed that market is always get things right and it has far much greater wisdom than individuals. Hence, EMH made investors and some of the economists that markets cannot be questioned. Consequently, the increase in prices in the housing and security market that led to global financial crisis raised concerns about EMH assumption that market prices are true. Besides, global financial crisis proved that there is existence of market bubbles, even though the idea is denied by economists such as Fama who supports the EMM. It was clear that market bubbles were some of the factors that led to global financial crisis that affected the financial markets in many countries in the world.
It is believed that investors were swayed by the notion that stock market reflects all available new information, they did not pay much attention to the need to verify and analyze the true value of the of stock (Ball, 2009). Consequently, investors, including market regulators failed to detect the potential market bubbles. The crisis also occurred because security market is dominated by price takers. A number of investors in the market view stock prices as correct, and they are not interested in verifying the asset values. Theoretically, investors cannot beat the market. However, practically, all investment funds are actively managed by financial experts and managers who are in better position to beat the market and influence stock prices in the security market. For instance, money flowing in the mutual funds actively follows past performance because of the ability of financial experts and companies’ managers to beat the market. Therefore, based on the 2008-2009 financial crisis, it is possible that the stock prices do not reflect all available information in the market, as some of the experienced and knowledgeable investors are able to influences stock prices to their own advantage.
At the same time, global financial crisis illustrates that investors do not make rational decisions or act rationally as contained in the EMH. It proved that market is full of speculators who are swayed by the trends in the stock market. Before the crisis, a number of investors poured money in the property market and money market because they believed that prices would continue to rise (Ball, 2009). Their argument was caused by market bubbles, which made them to believe that the current market prices were correct. Therefore, global financial crisis showed that EMH is not absolutely correct and that it is possible to influence market prices, and investors can sometimes act irrationally based on the available new information.
Apart from the global financial crisis, the 1987 stock market crash that can be used to raise doubt about EMH. The event led to the largest a single day decline in the stock market because it reduced by about 22.6% (Koning, 2013). According to the argument by Fama, the crash was due to rational response to the new economic falling flat. On the contrary, Robber Shiller conducted a survey immediately after the crash, using investors as participants. Shiller found that about 70% of investors agreed that the crash was due to market psychology.
It became apparent that the crash was caused by a few established investors who had the power to influence market forces. What became clear after the crash was that investors do not react passively to the underlying fundamental phenomena taking place in the stock market. Instead, they create stories that when acted upon by a significant number of people can cause fundamental changes in the market. For instance, it is argued that hedge fund giant George Soros used his firm known as Quantum Fund to publish a speculative stock price chart in the Wall Street Journal that led to the crash. In addition, it also came apparent that expectations are the main driving force behind stock market and not availability of new information as contained in the EMH. Experienced investors are capitalizing on the market psychology to influence stock prices as explained by some of the scholars such as Shiller. Hence, 1987 stock market crash is another example raising questions about the viability of the EMH.
The event is a clear illustration that investors are overacting to the market due to psychological reasons. It shows that investors always overact to previous information without taking a lot of interest in the new information. Therefore, it proves that investors are engaged in conservatism, as they would prefer to do the same thing as was done in the past. For instance, the 1987 stock market crash was associated with the similar crash that took place in 1929. The Wall Street Journal published a chart of stock price in 1987 that was superimposed on the on the stock price that led to 1929 crash (Koning, 2013). Consequently, investors and market regulators overreacted to the market based on the psychological reasons.
In addition, the event illustrates that investors do not make rational decisions based on the available information; rather, they observe actions and decisions made by other to make choices, which are always similar. They may decision that are independent of their own private information. Therefore, it is possible for the all available market information to be overturned by the private information published by a few investors. For instance, after publishing the stock price stock trends in the Wall Street Journal, Soros made investors to overlook the market information that were available, which led to irrational decisions. This is another example that shows that market is not efficient, but it is just being controlled by a few individuals.
Some of the anomalies associated with EMH also raise concerns about the theory. Size effect is one of the anomalies that raise a lot of concerns about the EMH. Based on the findings of studies that have been conducted by economists such as Kenneth French, firms with small market capitalization tend to outperform those with large market capitalization (Schwert, 2003). The anomaly contradicts EMH’s assertion that when an investors gain profit, then all players in the market also earn profits. The ability of small firms to outperform their larger counterparts is an indication that some investors can get losses while others are earning profits. The valuation effect anomaly also raises concerns about the EMH. Studies have found that companies with low price multiples outperform those with high price multiple, which also show that investors use the available information in different ways.
Therefore, global financial crisis that occurred between 2008 and 2009, the 1987 stock market crash, and some of the anomalies that are associated with EMH are some of the examples that raise doubts about the theory that has received wide acceptance, especially from investors and economists. The events have proved that investors have the ability to beat the market contrary to what is contained in the EMH. The global financial crisis has also discredits the notion that market prices are always right because investors in housing and security markets got it wrong when they saw prices rising. As a result, even though EMH plays important role in the decision-making and actions taken by investors, it is not perfect and it can lead to economic crisis as the ones witnessed in 1987 and 2008. Investors should not entirely depend on EMH in decision-making, but they should use other market factors as well.
There is no doubt that EMH is an important theory is used by many investors, companies, and financial managers to operate in various markets, especially security markets. It helps players in the security markets in making crucial decisions that can lead to profits and reduce risks. In this regard, it is one of the fundamental theories that explain the movement of asset prices. Its main assumption is that markets operate efficiently and stock prices reflect all the information available. However, the world is more complex and its operations cannot be explained by one single model such as EMH. Therefore, relying on pricing models such EMH can lead to economic crises as in the case of 2008 financial global crisis. As much as investors are free to use EMH model, they should also be sensitive to its limitations and anomalies in the market.
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