Efficient Market Hypothesis
Daniel Kahneman and Amos Tversky proposed their award winning prospect theory which forms the foundations of behavioural economics to explain and give remedies to the fallacies in the Efficient Market Hypothesis. In fact behavioural economics and finance came into prominence because it was able to satisfactorily explain the market anomalies that this theory could not explain, hence, study of this hypothesis forms an integral part of behavioural finance, to understand BF better.
Eugene Fama laid the EMH’s empirical foundations, defines efficient market hypothesis as “the simple statement that security prices fully reflect all available information. A precondition for this strong version of the hypothesis is that information and trading costs, the costs of getting prices to reflect information, are always zero”. This meant that any information regarding the stock is reflected in its price when the transaction costs are assumed to be nil, and that the market always knows any information about a stock.
The Roots of Efficient Market Hypothesis
The central theory behind the Efficient Market Hypothesis is that financial markets are efficient in the sense that investors within these markets process information instantaneously and the prices completely reflect all existing information. The following is a description of each the three different types of the market efficiency:
1) The weak form: The market is efficient with respect to the history of all past market prices and information is fully reflected in securities values.
2) The semi-strong form: The market is efficient in which all publicly available information is fully reflected in securities values.
3) The strong form: The market is efficient in regards to all information is fully reflected in securities prices.
EMH can be illustrated with the following example,
A student and his professor who are walking down the street. The student spots an Rs.100 note on the pavement and stoops down to pick it up. The professor then tells him not to waste his time for “Had the bill actually been there, it would have been picked up”. That, in essence, is the concept of the “Efficient Market Hypothesis.” Whenever any new information arises, it spreads so rapidly that stock prices almost instantaneously reflect the change. Thus, no study of stocks and careful stock selection should help over random stock selection. This is because all the effects of data being studied are already reflected in the information.
The efficient market idea contends that prices of securities in public capital markets always reflect all available information about the underlying businesses they represent. In its time the theory has been described as “dazzling” and as an “enormous theoretical and empirical success.” The entire field of academic finance was created on its basis, spreading to every department of every university, and ultimately penetrating trading, board, court and class rooms worldwide.
Despite that success, the EMH suffered from theoretical and empirical limitations or exceptions. This provided the foundation to the creation and the eventual growth of behavioural finance.
The theoretical challenges that EMH faced were:
- Difficult to sustain the case that, investors are fully rational. In fact investors are seen to be quasi rational in their behaviour;
- Assumptions made in deriving the theory, transaction cost in big trades can at times be very costly and can play an important role in the decision making.
- People react to irrelevant information trade on noise rather than information. This renders the point that all information is reflected in the price pointless, as most of it is just noise (rumors, false news, etc.);
- What investors actually do?
Investors are seen not to use the information in an optimum way and they do not process the information correctly. They are seen to follow advice of financial gurus, fail to diversify, actively trade sell winning stocks, hold onto losing stocks, follow patterns etc.
The empirical challenges to EMH pointed fallacy at its every level
As to its claim that past prices give no profitable trading advantage (weak form efficiency), evidence comparing the performance of winning and losing portfolios shows that losers do way better and winners way worse than standard risk models (like CAPM) explain.
Also, EMH’s claim about public information (semi-strong form efficiency), is infected with anomalies in it. Stocks of smaller companies tend to outperform those of large; highly priced stocks are observed to get lower average returns in the future than those with lower prices. Observations like these imply that it is possible to get superior returns by buying the lower priced stocks.
This goes against the fundamental belief of EMH which states that investors cannot outperform the market, i.e. it cannot get returns higher than the market.
Concerning the more general EMH claim that there should be no reactions to non-information, plenty of evidence shows that all sorts of stock price movements cannot be explained in terms of changes in information about the related businesses. Consider an example that stocks selected for inclusion in a major stock index–such as the Standard & Poor’s 500, for example–tend to enjoy a price increase even though the inclusion alters nothing about their probable future business performance.
These anomalies that plagued EMH were the starting point for research into behavioural finance. It found an explanation to the deviations shown by the markets to the assumptions and beliefs of EMH. It plays a critical role in identifying such situations and making use of it to improve investor returns.
We will talk about how exactly Behavioural Finance grew using the imperfections in the EMH someday in detail. In the meanwhile you can use these places to read and know more about EMH:
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