The Principles Of Efficient Market Hypothesis

Introduction

The efficient market hypothesis (EMH) is the idea that stock prices in a market instantaneously reflect all available information in an unbiased fashion, suggesting that it is impossible to consistently generate abnormal returns (Fama, 1970). Challenging the EMH, behavioural finance studies financial markets through the lens of psychology (Shleifer, 2000). It takes the insights of psychological research and applies them to financial decision- making. It will be asserted that whilst mostly true the EMH cannot explain certain inconsistencies within the market where behavioural finance can. This essay will therefore evaluate the strengths and weaknesses of the EMH and behavioural finance as well as the implications of these theories for the future directions of the fund.

Efficient Market Hypothesis

The efficient market hypothesis (EMH) asserts that stock prices fully reflect all available information. This means that investors cannot generate profits in the equity market by trading on public information such as historical prices. This notion of market efficiency is critical because it helps investors make choices among securities that reflect firms’ activities based on the assumption that prices always incorporate all available information (Fama, 1970). The EMH is also connected to ‘random walk’, a theory that describes a price sequence where all following price changes represent random departure from previous prices. The logic of random walk is that if information is instantly reflected in stock prices, tomorrow’s price changes will exclusively reflect tomorrow’s news and will be independent of the price change today. As a result, prices fully reflect all information, and investors using indexed funds should obtain returns as generous as that achieved by the experts (Malkiel, 2003). Fama (1970) suggested that the market is just efficient with respect to information set. He proposed degree of market efficiency, based on the definition of information set:

• Weak-form efficiency. In the weak form it is not possible for investors to make excess returns by using trading strategies based on historical price information. Analysis which utilises past market prices such as the ‘technical analysis’ would not be profitable in such a market.
• Semi-strong efficiency. The semi-strong efficiency states that it is not possible to use any publicly available information to earn excess returns. Publicly available information includes financial statements and annual reports of companies. This implies that fundamental analysis is useless in terms of creating excess returns (Fidrmuc, Korczak & Korczak, 2011).
• Strong- form efficiency. The strong-form of market efficiency asserts that prices reflect all information including information that is not publicly available. In the strong-form insider information cannot generate abnormal returns. However, this seems unlikely as in our own world studies have shown that insider information often generates abnormal returns (Fidrmuc et al. , 2011).

Event studies

An argument for market efficiency is the accurate and swift stock price correction after key announcements such as mergers, acquisitions and divestitures. Research into stock price changes that occur after key announcements are labelled as ‘event studies’. In a study conducted by Shleifer (2000), it was found that stock price drift begins before the actual announcement, showing market anticipation or information leaks. On the announcement day, the stock price would go up or fall down to its new intrinsic value and stay somewhat constant for a month (Malkiel, 2003). The way in which these investors reacted to corporate news appear consistent with a market that is semi-strong form efficient. Passive versus active fund management Active strategies select individual securities, generally with the objective of outperforming a previously identified benchmark. Passive management mirrors the benchmark index, and because of this, there is no need for a manager to pick specific investments. The comparison between these two schools of management is relevant because according to the EMH actively managed funds should not be able too consistently outperform the benchmarks. Figure 1 shows the percentage of active funds that were outperformed by the benchmark index, namely the Vanguard S&P500 index fund.

Even during the US’s early 2000s recession, when the index fund was disadvantaged by being fully invested while the typical actively managed fund held between 5 and 10% of its assets in cash, more than 50% of actively managed funds were outstripped by the index fund (Malkiel, 2003). Further evidence from a study conducted by Allen, Brealey and Myers (2011) observed that U. S active funds only had superior returns in comparison to their benchmarks in 16 of the 47 years studied. Malkiel (2003) corroborated this finding estimating that 66% of active funds experienced lower returns than their benchmarks over a 40 year period. All of these studies seem to conclude that rarely do funds consistently outperform their benchmarks. Malkiel (2011) argued in addition, that the best active fund managers in one year only generated an average return the following year. These findings were consistent with Fama’s (1970) conclusions that in an efficient market you cannot consistently generate abnormal returns. It also demonstrates that a passive management is the safest strategy in regards to future growth of a firm due to the obvious difficulties associated with actively managed funds.

Limits to arbitrage argument

One of the foremost arguments against the EMH are based on limits to arbitrage. Theory suggests that equal assets should have an equal price in similar markets (Shleifer & Vishny, 1995). If prices differed between markets, arbitragers would buy in the cheaper market and sell in the expensive one (Shleifer & Vishny, 1995). This should generate a return, and would push the price into equilibrium. Grossman and Stiglitz (1980), argued that markets operate in a ‘equilibrium disequilibrium’ rather than an equilibrium. The reason for this ‘equilibrium disequilibrium’ is that arbitrage is costly, so prices cannot fully reflect information in order to provide compensation to informed market participants who incur costs to obtain information (Grossman & Stiglitz, 1980).

As a result, Grossman and Stiglitz (1980) argue that a perfectly efficient market would cause any competitive market to fail as no market participants would be willing to bear the costs to price data into the market (Grossman & Stiglitz, 1980). EMH proponents contend that informed traders price information into the market without any compensation, and in addition suggest that the existence of information costs only repudiates strong-form market efficiency. (Elton et al. , 1991; Fama 1970). The EntreMed IncidentSpecific examples of inconsistencies in the EMH include a company named EntreMed. In one weekend EntreMed jumped 600% following the publication of news that had already been made available to the public five months earlier regarding a soon to be released new cancer drug (Hirshleifer, 2015). The key assumption of the EMH is that prices rapidly adjust to new information and accurately reflect all the public information available therefore such an occurrence has no reasonable explanation within the hypothesis (Hirshleifer, 2015).

However, whilst the EMH has no explanation other schools of thought use psychology and sociology to explain such an occurrence. Behavioural finance argument Market efficiency, in the sense that market prices reflect fundamental market characteristics and that abnormal returns on average are levelled out in the long run, has been challenged by behavioural finance. Behavioural finance analyses how investor psychology can affect prices in financial markets. Psychology of markets Richard Thaler and Robert Shiller are considered the founding fathers of behavioural economics and have made many contributions to the field of study. Both men believe that EMH overlooks the tendency for investors to act irrationally, risk tolerant, to burden uncertainty and whom prefer less than more.

For instance, Thaler (2002) researched and identified systematic misconceptions that investors tend to make, such as, overconfidence in rising price markets, over-pessimism in falling markets, herd mentality, optimism and wishful thinking, conservatism and availability biases. He found that the decision-making process of investors in selecting an investment are affected by the aforementioned behavioural factors. Shiller (2000) supplemented Thaler’s work by suggesting that these factors lead to investment bubbles submitting that future stock prices are to some degree predictable. This would imply that the behavioural issues identified by Thaler can be used by investors to create winning investment strategies. Shiller has also conducted a considerable number of practical studies, which has given behavioural finance a highly empirical association. Shiller’s (2003) work also highlighted the existence of anomalies such as the January effect. Momentum trading strategy Another such anomaly known as momentum investing, exploits past trends in stock prices. This technical analysis purchases winner stocks, those stocks that made the best returns over some short time period, and simultaneously short selling losers, those stocks that earned the worst returns over the same period (Chan, Jegadeesh and Lakonishok, 1996). If the markets were weak-form efficient as the EMH asserts then in theory it should not be possible to profit from historical trends using a simple, costless strategy such as momentum trading.

Fundamentally, the result suggests more evidence against the EMH; specifically weak form efficiency. This is because the only information needed to construct portfolios is historical prices, which are the simplest form of information and available to all market participants. Contrarian Trading StrategyA contrarian investor is an investor that believes in generating abnormal returns through selling what others are buying and buying what others are selling. Contrarian strategies in equity market are well known phenomenon as stocks that performed poorly in the past rebound in the future. Evidence for the contrarian investment strategy was published by De Bondt and Thaler (1985). They first encountered the phenomenon in US stock markets. Finding that that 3 to 5 years after observing a past performance based portfolio, losers' portfolios outperformed winners' portfolios by approximately 0. 694% per month over 3 years and 0. 6% per month for 5 years post-ranking period (Wouassom, 2017). Chopra, Lakonishok and Ritter (1992) examined stock return overreaction on the NYSE stock returns from 1926 to 1986. They found that the losers outperform the winners by approximately 0. 542% per month on annual return and 0. 792% per month (Chopra et al. , 1992). Behavioural finance suggests that principle cause for these excess returns is overreaction; the idea that investors make frequent and predictable errors. Shiller (1981) suggested that investors tend to attach disproportionate importance to short-run economic developments. Regardless, evidence seems to suggest that contrarian profit is abnormal.

Fusion investing

Fusion investing is a hybrid approach that integrates both fundamental value and investor sentiment (Bettman, Sault & Schultz, 2009). In practice it is a ‘fusion’ of the fundamental and technical analysis which should not be profitable in either a semi-strong or weak form efficient market. it should be noted that empirical evidence in regards to the performance of this strategy is very lacking there have been famous examples of its success. (Bettman et al. , 2009). For instance, using $36,000, Nicolas Darvas made over $2,000,000 in the stock market by combining both strategies, in a mere 18 months (Bettman et al. , 2009). Likewise, John Palicka (2011), turned $50 million into $1. 5 billion through fusion investing, in just 11 years. The above seems to demonstrate that fusion strategy is certainly capable of generating what appear to be abnormal profits which would again suggest that the markets are not as efficient as Fama (1970) once assumed. Conclusion on market efficiency. Although the EMH has been widely tested and has largely been found consistent within the semi-strong form of efficiency there remain systematic deviations from theoretical expectations, so called anomalies created by irrational behaviour. These inconsistencies provide the framework for behavioural finance which has rationalised these anomalies through the lenses of psychology. For an actively managed fund these anomalies that arise in markets open up the possibility of profit opportunities by using trading strategies such as the contrarian, momentum and fusion strategies.

Although consistent abnormal returns are obviously difficult to generate, as shown when comparing the profitability between passive and active management firms, these trading strategies demonstrate that it is not impossible. Evidence has demonstrated that the momentum effect can effectively and consistently produce returns that outperform their benchmarks. Though seemingly less profitable the contrarian strategy also appeared to be able to achieve abnormal returns as loser stocks were seen to consistently outperform the winners. Likewise fusion investing, though not studied to the extent of the aforementioned, also provides success stories in generating excess returns. Therefore, the fund would wisely be directed to utilise these anomalies and the opportunities they create as highlighted by behavioural finance but also to be aware that the EMH and its principles remain mostly accurate.