A discussion of the efficient market hypothesis theory
Executive Summary
The efficient market hypothesis proposes that all markets are perfect and efficient and therefore the stock prices listed on the financial market reflect all the information available regarding the underlying companies. Various investors can only achieve the same profits over specified period of time and no investor can gain an advantage over the other. However, this has been challenged by a number of scholars in the past who propose that the markets are not efficient and investors have the opportunity of gaining short term profits on their investments. There have also been a number of misconceptions regarding the EMH theory which are discussed extensively by scholars in favour of the theory in the past years.
1. Introduction
The efficient market hypothesis (EMH) theory was developed by Eugene Fama and was aimed towards the evaluation of the achievement of short term profits in the financial markets. The author proposed that it is practically impossible for investors to buy undervalued stock and sell them later at higher values. In addition to this, the author also proposed that the financial markets across the globe are efficient and thus the stocks enlisted on these markets include all the information relevant to the underlying companies. As a result of this, investors are unable to access additional knowledge and gain profits over certain stocks in the market.
There have been several critics of the EMH over the years. The basic assumptions of the theory have been challenged at large by scholars around the globe. This report looks forward towards detailing the key assumptions of the EMH theory as well as the criticism it has faced over the years. The misconceptions regarding the underlying assumptions of EMH will also be discussed. At the end of the report, a brief conclusion is also included in order to conclude the key findings and discussions of the report in a nutshell.
2. Efficient market hypothesis (EMH)
As outlined by Malkiel & G (2003) the efficient market hypothesis proposes that it is ‘impossible’ for investors to beat the market. The core reason behind this is that the share prices prevailing in the stock market embed all the information and trends relevant to the stock. As a result of this, no investor can gain information which may lead him/her towards exceptional profits and allow him/her to beat the market profitability trends.
The efficient market hypothesis proposes that any upcoming news regarding significant factors that are going to influence the underlying value of a particular stock is spread very quickly in the market and thus any potential changes are incorporated in the stock prices (Malkiel & G, 1991).
As outlined by the efficient market hypothesis, there are three degrees of markets with respect to efficiency. These are weak, semi-strong and strong markets respectively (Malkiel, et al., 1970).
2.1 Weak efficiency markets
In weak efficiency markets, information available to the past trends and performance of companies is available to the investors. However, no information related to the current or future performance is reflected in the stocks floating in the financial market.
2.2 Semi-strong efficiency markets
Semi-strong efficiency markets are those in which all the knowledge which is publically available is embedded into the underlying value of shares in the financial markets. However, no investor is able to use any technical and/or fundamental analysis in order to gain favourable returns in the market.
2.3 Strong efficiency markets
In such markets, all information is available to the investors in the financial market. This includes and insider information regarding the future endeavours of the companies. Therefore, no investor is able to gain any advantage even if insider information is available to them (Laffont, et al., 1990).
The efficient market hypothesis assumes that all the information regarding the underlying stocks is reflected in the stock prices. Therefore, it proposes that the financial markets are efficient and therefore investors are able to trust the prices listed on the financial markets. The theory proposes that the prices in the financial market are based upon a reflection of their expected cash flows in the future and are adjusted for factors such as liquidity risk, credit risk and volatility of the stocks. Any changes in the prices of the stock are random as these are based upon new and unforeseeable information, previously unable to the market as well as the investors.
3. Anti-efficient market hypothesis theories
Over the years, a number of scholars have proposed their concerns with the assumptions of the EMH theory. According to recent researches, the assumptions of EMH do not lie true in the modern financial market. The key critics of the assumptions proposed by EMH are detailed in this section of the report.
3.1 Forecasting profits and returns
The EMH theory outlines that investors cannot forecast future profits or returns based on past trends. Therefore, any statistical or financial review regarding the underlying performance of the stock cannot result in certain investors gaining more than the others. The theory therefore suggests that the returns generated by an expert investor is the same as that generated by a newbie investor on a particular profit. However, this does not hold true in the modern financial market. In the modern financial market, there are several tools and techniques which are used by investors in order to value an underlying stock in the market (Malkiel & G, 2005). For Instance, a particular investor may invest in a stock on the basis of evaluating it as an opportunity to explore undervalued opportunities in the market, however, another investor might be investing on the basis of past growth rates and financial trends of the stock. As a result of this, the underlying value of the stock will be different in the eyes of both the investors. This raises a question mark on the hypothesis of the valuation of a stock available in the financial stock market.
3.2 Achievement of higher profitability
The efficient market hypothesis claims that no investor in the market is able to achieve a higher return than other investors operating in the same market. This is backed by the idea that all the investors in a particular market have more or less the same information regarding the stocks being traded. However, modern research illustrates that this is not true. The study conducted by Ball & Ray (2009) illustrates that a number of investors are able to achieve returns different from one another. The practical illustration of this is in the form of a mutual fund industry where different investments are able to gain different returns, although operating in the same market (Bogle & John, 1994). Furthermore, it is not certain that an investment may necessarily only make profit as numerous investments can also result in losses for the investors.
4. Misconceptions regarding the EMH and clarification of the critics
As detailed in the earlier section of this report, the theories based on efficient market hypothesis are widely criticised by scholars over the years. However, scholars abiding by the assumptions of the theory state that there are several misconceptions regarding the EMH which have led to the claims of its critics (Beechey, et al., 2000).
4.1 Outperforming the market
A number of modern critics have proposed that the assumption of outperforming the market embedded in the EMH is not true. An example of this is the practical investing life of Warren Buffett who has practically beaten the financial several times and has made significant profits over his investing timeline (Brown, 2014). However, it is important to understand that the EMH does not propose that an investor cannot beat the market, but rather proposes that it is not possible for investors to beat the financial market and make significant gains on a continuous basis (Daniel, et al., 1999). The only way such profits are based is based on luck rather than any analysis or forecast.
4.2 Efficient markets in the real world
The EMH proposes that markets are efficient and all information is reflected in a particular stock being traded at a market. However, it has been seen that the prices of various stocks and securities tend to change on a continuous basis. This change is illustrated on yearly, quarterly, monthly, weekly or even daily basis. It has also been seen that some stock prices change within hours and yield large profits or losses to the investors. Hence, critics propose that the assumption of EMH proposing that markets are efficient is incorrect. However, it is important to understand that a rapid change in the price of an underlying stock itself is due to a changing circumstance or introduction of new information regarding that particular companies in the market. The change in price of the underlying stocks in the market itself illustrates that the markets are perfect as they are embedding all the fluctuations observed in information regarding the underlying stocks within its market price (Davidson & Paul, 2003).
5. Conclusion
In conclusion, there has been considerable debate regarding the achievement of significant profits in the financial market over the years. The efficient market hypothesis proposes that investors are unable to gain significant profits in the short term on a consistent basis. However, this statement has been challenged by a number of scholars and practical cases have illustrated that such profits can be achieved. The prices in the modern financial markets adjust to any upcoming changes in the information of underlying stocks and thus illustrate that the markets are highly efficient.
Despite its extensive critics, the assumptions of the efficient market hypothesis theory still hold true more or less, in the modern financial markets. A number of investors agree that it is impossible or near to impossible to beat the financial market and gain significant profits in the short term. I myself conducted a research in the previous report and was involved in the buying and selling of various stocks in order to beat the market. However, I was not able to beat the market and concluded that the underlying assumptions of EMH hold true. There is still room for much research regarding the achievement of healthy short term profits in the financial markets for investors around the globe.
References
Ball & Ray, 2009. The global financial crisis and the efficient market hypothesis: What have we learned?. Journal of Applied Corporate Finance, 21(4), pp. 8-16.
Beechey, Gruen, M. a., Vickery, D. W. a. & others, J. a., 2000. The efficient market hypothesis: a survey. s.l.: Reserve Bank of Australia, Economic Research Department.
Bogle & John, 1994. Bogle on Mutual Funds: New Perspectives for the Intelligent Investor.
Brown, J. M., 2014. That time Buffett smashed the Efficient Market Hypothesis. [Online]
Available at: http://thereformedbroker.com/2014/01/03/that-time-buffett-smashed-the-efficient-market-hypothesis/
[Accessed 7 April 2016].
Daniel, Titman, K. a. & Sheridan, 1999. Market efficiency in an irrational world. Financial Analysts Journal, 55(6), pp. 28-40.
Davidson & Paul, 2003. Financial markets, money, and the real world. s.l.: Edward Elgar Publishing.
Laffont, Maskin, J.-J. a. & S, E., 1990. The efficient market hypothesis and insider trading on the stock market. Journal of Political Economy, pp. 70-93.
Malkiel, Fama, B. G. a. & F, E., 1970. Efficient capital markets: A review of theory and empirical work. The journal of Finance, 25(2), pp. 338-417.
Malkiel & G, B., 1991. Efficient market hypothesis. In: The World of Economics. s.l.: Springer, pp. 211-218.
Malkiel & G, B., 2003. The efficient market hypothesis and its critics. The Journal of Economic Perspectives, 17(1), pp. 59-82.
Malkiel & G, B., 2005. Reflections on the efficient market hypothesis: 30 years later. Financial Review, 40(1), pp. 1-9.
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