Efficient market hypothesis

The efficient-market hypothesis (EMH) states (in its original formulation) that asset prices fully reflect all available information. A direct implication is that it is impossible to “beat the market” consistently on a risk-adjusted basis since market prices should only react to new information or changes in discount rates (the latter may be predictable or unpredictable).

The EMH was developed by Professor Eugene Fama who argued that stocks always trade at their fair value, making it impossible for investors to either purchase undervalued stocks or sell stocks for inflated prices. As such, it should be impossible to outperform the overall market through expert stock selection or market timing, and that the only way an investor can possibly obtain higher returns is by chance or by purchasing riskier investments.

His 2012 study with Kenneth French confirmed this view, showing that the distribution of abnormal returns of US mutual funds is very similar to what would be expected if no fund managers had any skill -a necessary condition for the EMH to hold.

There are three variants of the hypothesis: “weak”, “semi-strong”, and “strong” form. The weak form of the EMH claims that prices on traded assets (e.g., stocks, bonds, or property) already reflect all past publicly available information. The semi-strong form of the EMH claims both that prices reflect all publicly available information and that prices instantly change to reflect new public information. The strong form of the EMH additionally claims that prices instantly reflect even hidden “insider” information. The believers in EMH state that market efficiency does not mean having no uncertainty about the future, that market efficiency is a simplification of the world which may not always hold true, and that the market is practically efficient for investment purposes for most individuals.

Critics have blamed the belief in rational markets for much of the late-2000s financial crisis. In response, proponents of the hypothesis have stated that market efficiency does not mean having no uncertainty about the future, that market efficiency is a simplification of the world which may not always hold true, and that the market is practically efficient for investment purposes for most individuals. Investors and researchers have disputed the efficient-market hypothesis both empirically and theoretically. Behavioral economists attribute the imperfections in financial markets to a combination of cognitive biases such as overconfidence, overreaction, representative bias, information bias, and various other predictable human errors in reasoning and information processing. These errors in reasoning lead most investors to avoid value stocks and buy growth stocks at expensive prices, which allow those who reason correctly to profit from bargains in neglected value stocks and the overreacted selling of growth stocks. Investors prefer riskier funds in spring and safer funds in autumn.

Empirical evidence has been mixed, but has generally not supported strong forms of the efficient-market hypothesis. According to Dreman and Berry, in a 1995 paper, low P/E stocks have greater returns. In an earlier paper Dreman also refuted the assertion by Ray Ball that these higher returns could be attributed to higher beta, whose research had been accepted by efficient market theorists as explaining the anomaly in neat accordance with modern portfolio theory. One can identify “losers” as stocks that have had poor returns over some number of past years. “Winners” would be those stocks that had high returns over a similar period. The main result of one such study is that losers have much higher average returns than winners over the following period of the same number of years. A later study showed that beta ($\beta$) cannot account for this difference in average returns. This tendency of returns to reverse over long horizons (i.e., losers become winners) is yet another contradiction of EMH. Losers would have to have much higher betas than winners in order to justify the return difference. The study showed that the beta difference required to save the EMH is just not there.

Speculative economic bubbles are an obvious anomaly, in that the market often appears to be driven by buyers operating on escalating market sentiment/ irrational exuberance, who take little notice of underlying value. These bubbles are typically followed by an overreaction of frantic selling, allowing shrewd investors to buy stocks at bargain prices. Rational investors have difficulty profiting by shorting irrational bubbles because, in the words of a famous saying attributed to John Maynard Keynes, “Markets can stay irrational longer than you can stay solvent.” Sudden market crashes as happened on Black Monday in 1987 are mysterious from the perspective of efficient markets, but allowed as a rare statistical event under the weak-form of EMH. Benoit Mandelbrot has argued that market bubbles are not anomalous but rather characteristic of price dynamics described by power laws such as Pareto, Zipf or Tracy-Widom combined with persistence in price change trends.

The construction of prices and the information in the market is a main issue in computer science.

See also

Economic Liberalism, Behavioral economics, Algorithmic game theory

Material

• http://www.businessinsider.com/warren-buffett-on-efficient-market-hypothesis-2010-12
• “Investors are finally seeing the nonsense in the efficient market theory”. The Telegraph.

Papers

• Fama E, French K. (1992). The Cross-Section of Expected Stock Returns. Journal of Finance 47:427-465
• Malkiel, B. G. (2003). The efficient market hypothesis and its critics. The Journal of Economic Perspectives, 17(1), 59-82.
• Geltner, D. (2009). Estimating market values from appraised values without assuming an efficient market. Journal of Real Estate Research.
• Granger, Clive W. J.; Morgenstern, Oskar (2007). Spectral Analysis Of New York Stock Market Prices. Kyklos 16 (1): 1-27.

Books

• Fox, Justin (2009). Myth of the Rational Market. Harper Business.
• Cassidy, J. (2009). How markets fail: The logic of economic calamities. Macmillan.
• Sornette, D. (2009). Why stock markets crash: critical events in complex financial systems. Princeton University Press.