Efficient-market hypothesis

The efficient-market hypothesis (EMH) is a hypothesis in financial economics that states 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.

The efficient-market hypothesis was developed by 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.[1] His 2012 study with Kenneth French supported 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.[2]

There are three variants of the hypothesis: "weak", "semi-strong", and "strong" form. The weak form of the EMH claims that
trading information (levels and changes of prices and volumes) of traded assets (e.g., stocks, bonds, or property) are already
incorporated in prices. If weak form efficiency holds then technical analysis cannot be used to generate superior returns. The
semi-strong form of the EMH claims both that prices incorporate all publicly available information (which also includes
information present in financial statements, other SEC filings etc.). If semi-strong form efficiency holds then neither technical
analysis nor fundamental analysis can be used to generate superior returns. The strong form of the EMH additionally claims that
prices incorporate all public and non-public (insider) information, and therefore even insiders cannot expect to earn superior
returns (compared to the uninformed public) when they trade assets of which they have inside information.

There is no quantitative measure of market efficiency and testing the idea is difficult. So-called "effect studies" provide some of
the best evidence, but they are open to other interpretations.[3] Critics have blamed rational expectations for much of the financial
crisis of 2007–2008.[4][5][6] In response, proponents of the hypothesis have stated that market efficiency does not mean not
having any 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.[7]

Contents
Historical background
Impacts
Theoretical background
Weak-form efficiency
Semi-strong-form efficiency
Strong-form efficiency
Criticism
Behavioral psychology
EMH anomalies and rejection of the Capital Asset Pricing Model (CAPM)
View of some economists
Late 2000s financial crisis
Efficient markets applied in securities class action litigation
See also
Notes
 References
External links

Historical background
Benoit Mandelbrot claimed the efficient markets theory was first proposed by the French mathematician Louis Bachelier in 1900
in his PhD thesis "The Theory of Speculation" describing how prices of commodities and stocks varied in markets.[8] It has been
speculated that Bachelier drew ideas from the random walk model of Jules Regnault, but Bachelier did not cite him,[9] and
Bachelier's thesis is now considered pioneering in the field of financial mathematics.[10][9] It is commonly thought that
Bachelier's work gained little attention and was forgotten for decades until it was rediscovered in the 1950s by Leonard Savage,
and then become more popular after Bachelier's thesis was translated into English in 1964. But the work was never forgotten in
the mathematical community, as Bachelier published a book in 1912 detailing his ideas,[9] which was cited by mathematicians
including Joseph L. Doob, William Feller[9] and Andrey Kolmogorov.[11] The book continued to be cited, but then starting in the
1960s the original thesis by Bachelier began to be cited more than his book when economists started citing Bachelier's work.[9]

The efficient markets theory was not popular until the 1960s when the advent of computers made it possible to compare
calculations and prices of hundreds of stocks more quickly and effortlessly. In 1945, F.A. Hayek argued that markets were the
most effective way of aggregating the pieces of information dispersed among individuals within a society. Given the ability to
profit from private information, self-interested traders are motivated to acquire and act on their private information. In doing so,
traders contribute to more and more efficient market prices. In the competitive limit, market prices reflect all available
information and prices can only move in response to news. Thus there is a very close link between EMH and the random walk
hypothesis.[12]

Empirically, a number of studies indicated that US stock prices and related financial series followed a random walk model in the
short-term.[13] Whilst there is some predictability over the long-term, the extent to which this is due to rational time-varying risk
premia as opposed to behavioral reasons is a subject of debate. Research by Alfred Cowles in the 1930s and 1940s suggested that
professional investors were in general unable to outperform the market.

Impacts
The efficient-market hypothesis emerged as a prominent theory in the mid-1960s. Paul Samuelson had begun to circulate
Bachelier's work among economists. In 1964 Bachelier's dissertation along with the empirical studies mentioned above were
published in an anthology edited by Paul Cootner.[14] In 1965, Eugene Fama published his dissertation arguing for the random
walk hypothesis.[15] Also, Samuelson published a proof showing that if the market is efficient, prices will exhibit random-walk
behavior.[16] This is often cited in support of the efficient-market theory, by the method of affirming the consequent,[17][18]
however in that same paper, Samuelson warns against such backward reasoning, saying "From a nonempirical base of axioms you
never get empirical results."[19] In 1970, Fama published a review of both the theory and the evidence for the hypothesis. The
paper extended and refined the theory, included the definitions for three forms of financial market efficiency: weak, semi-strong
and strong (see below).[20]

It has been argued that the stock market is "micro efficient" but not "macro efficient". The main proponent of this view was
Samuelson, who asserted that the EMH is much better suited for individual stocks than it is for the aggregate stock market.
Research based on regression and scatter diagrams has strongly supported Samuelson's dictum.[21] This result is also the
theoretical justification for the forecasting of broad economic trends, which is provided by a variety of groups including non-
profit groups as well as by for-profit private institutions.
Further to this evidence that the UK stock market is weak-form efficient, other studies of capital markets have pointed toward
their being semi-strong-form efficient. A study by Khan of the grain futures market indicated semi-strong form efficiency
following the release of large trader position information (Khan, 1986). Studies by Firth (1976, 1979, and 1980) in the United
Kingdom have compared the share prices existing after a takeover announcement with the bid offer. Firth found that the share
prices were fully and instantaneously adjusted to their correct levels, thus concluding that the UK stock market was semi-strong-
form efficient. However, the market's ability to efficiently respond to a short term, widely publicized event such as a takeover
announcement does not necessarily prove market efficiency related to other more long term, amorphous factors. David Dreman
has criticized the evidence provided by this instant "efficient" response, pointing out that an immediate response is not necessarily
efficient, and that the long-term performance of the stock in response to certain movements are better indications.

Theoretical background
Beyond the normal utility maximizing agents, the efficient-market hypothesis requires that agents have rational expectations; that
on average the population is correct (even if no one person is) and whenever new relevant information appears, the agents update
their expectations appropriately. Note that it is not required that the agents be rational. EMH allows that when faced with new
information, some investors may overreact and some may underreact. All that is required by the EMH is that investors' reactions
be random and follow a normal distribution pattern so that the net effect on market prices cannot be reliably exploited to make an
abnormal profit, especially when considering transaction costs (including commissions and spreads). Thus, any one person can be
wrong about the market—indeed, everyone can be—but the market as a whole is always right. There are three common forms in
which the efficient-market hypothesis is commonly stated—weak-form efficiency, semi-strong-form efficiency and strong-
form efficiency, each of which has different implications for how markets work.

Weak-form efficiency
In weak-form efficiency, future prices cannot be predicted by analyzing prices from the past. Excess returns cannot be earned in
the long run by using investment strategies based on historical share prices or other historical data. Technical analysis techniques
will not be able to consistently produce excess returns, though some forms of fundamental analysis may still provide excess
returns. Share prices exhibit no serial dependencies, meaning that there are no "patterns" to asset prices. This implies that future
price movements are determined entirely by information not contained in the price series. Hence, prices must follow a random
walk. This 'soft' EMH does not require that prices remain at or near equilibrium, but only that market participants not be able to
systematically profit from market 'inefficiencies'.[22] and that, moreover, there is a positive correlation between degree of trending
and length of time period studied (but note that over long time periods, the trending is sinusoidal in appearance).[23] Various
explanations for such large and apparently non-random price movements have been promulgated.

There is a vast literature in academic finance dealing with the momentum effect identified by Jegadeesh and Titman.[24][25]
Stocks that have performed relatively well (poorly) over the past 3 to 12 months continue to do well (poorly) over the next 3 to 12
months. The momentum strategy is long recent winners and shorts recent losers, and produces positive risk-adjusted average
returns. Being simply based on past stock returns, the momentum effect produces strong evidence against weak-form market
efficiency, and has been observed in the stock returns of most countries, in industry returns, and in national equity market indices.
Moreover, Fama has accepted that momentum is the premier anomaly.[26][27]

The problem of algorithmically constructing prices which reflect all available information has been studied extensively in the
field of computer science.[28][29]

Semi-strong-form efficiency
In semi-strong-form efficiency, it is implied that share prices adjust to publicly available new information very rapidly and in an
unbiased fashion, such that no excess returns can be earned by trading on that information. Semi-strong-form efficiency implies
that neither fundamental analysis nor technical analysis techniques will be able to reliably produce excess returns. To test for
semi-strong-form efficiency, the adjustments to previously unknown news must be of a reasonable size and must be
instantaneous. To test for this, consistent upward or downward adjustments after the initial change must be looked for. If there are
any such adjustments it would suggest that investors had interpreted the information in a biased fashion and hence in an
inefficient manner.

Strong-form efficiency
In strong-form efficiency, share prices reflect all information, public and private, and no one can earn excess returns. If there are
legal barriers to private information becoming public, as with insider trading laws, strong-form efficiency is impossible, except in
the case where the laws are universally ignored. To test for strong-form efficiency, a market needs to exist where investors cannot
consistently earn excess returns over a long period of time. Even if some money managers are consistently observed to beat the
market, no refutation even of strong-form efficiency follows: with hundreds of thousands of fund managers worldwide, even a
normal distribution of returns (as efficiency predicts) should be expected to produce a few dozen "star" performers.

Criticism
Investors, including the likes of Warren Buffett,[32] 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 have been researched by psychologists such as Daniel Kahneman, Amos
Tversky and Paul Slovic and economist Richard Thaler. 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.

Empirical evidence has been mixed, but has generally not supported strong forms of the efficient-market hypothesis[33][34][35]
According to Dreman and Berry, in a 1995 paper, low P/E stocks have greater returns.[36] In an earlier paper Dreman also refuted
the assertion by Ray Ball that these higher returns could be attributed to higher beta,[37] whose research had been accepted by
efficient market theorists as explaining the anomaly[38] in neat accordance with modern portfolio theory.

Behavioral psychology
Behavioral psychology approaches to stock market trading are among some of the more promising alternatives to EMH (and
some investment strategies seek to exploit exactly such inefficiencies). But Nobel Laureate co-founder of the programme Daniel
Kahneman —announced his skepticism of investors beating the market: "They're just not going to do it. It's just not going to
happen." Indeed, defenders of EMH maintain that Behavioral Finance strengthens the case for EMH in that it highlights biases in
individuals and committees and not competitive markets. For example, one prominent finding in Behaviorial Finance is that
individuals employ hyperbolic discounting. It is demonstrably true that bonds, mortgages, annuities and other similar financial
instruments subject to competitive market forces do not. Any manifestation of hyperbolic discounting in the pricing of these
obligations would invite arbitrage thereby quickly eliminating any vestige of individual biases. Similarly, diversification,
derivative securities and other hedging strategies assuage if not eliminate potential mispricings from the severe risk-intolerance
(loss aversion) of individuals underscored by behavioral finance. On the other hand, economists, behaviorial psychologists and
mutual fund managers are drawn from the human population and are therefore subject to the biases that behavioralists showcase.
By contrast, the price signals in markets are far less subject to individual biases highlighted by the Behavioral Finance
programme. Richard Thaler has started a fund based on his research on cognitive biases. In a 2008 report he identified complexity
and herd behavior as central to the global financial crisis of 2008.[39]
Further empirical work has highlighted the
impact transaction costs have on the concept
of market efficiency, with much evidence
suggesting that any anomalies pertaining to
market inefficiencies are the result of a cost
benefit analysis made by those willing to
incur the cost of acquiring the valuable
information in order to trade on it.
Additionally the concept of liquidity is a
critical component to capturing
"inefficiencies" in tests for abnormal returns.
Any test of this proposition faces the joint
hypothesis problem, where it is impossible to
ever test for market efficiency, since to do so
requires the use of a measuring stick against
which abnormal returns are compared —one
cannot know if the market is efficient if one Price-Earnings ratios as a predictor of twenty-year returns based
does not know if a model correctly stipulates upon the plot by Robert Shiller (Figure 10.1,[30] source (http://irrationalex
uberance.com/shiller_downloads/ie_data.xls)). The horizontal axis shows
the required rate of return. Consequently, a
the real price-earnings ratio of the S&P Composite Stock Price Index
situation arises where either the asset pricing
as computed in Irrational Exuberance (inflation adjusted price
model is incorrect or the market is inefficient, divided by the prior ten-year mean of inflation-adjusted earnings).
but one has no way of knowing which is the The vertical axis shows the geometric average real annual return on
case. investing in the S&P Composite Stock Price Index, reinvesting
dividends, and selling twenty years later. Data from different twenty-
The performance of stock markets is year periods is color-coded as shown in the key. See also ten-year
correlated with the amount of sunshine in the returns. Shiller states that this plot "confirms that long-term investors
city where the main exchange is located.[40] —investors who commit their money to an investment for ten full
years—did do well when prices were low relative to earnings at the
A key work on random walk was done in the beginning of the ten years. Long-term investors would be well
advised, individually, to lower their exposure to the stock market
late 1980s by Profs. Andrew Lo and Craig
when it is high, as it has been recently, and get into the market when
MacKinlay; they effectively argue that a
it is low."[30] Burton Malkiel, a well-known proponent of the general
random walk does not exist, nor ever has.[41] validity of EMH, stated that this correlation may be consistent with an
Their paper took almost two years to be efficient market due to differences in interest rates.[31]
accepted by academia and in 1999 they
published "A Non-random Walk Down Wall
St." which collects their research papers on the topic up to that time.

EMH anomalies and rejection of the Capital Asset Pricing

Model (CAPM)
While event studies of stock splits are consistent with the EMH (Fama, Fisher, Jensen, and Roll,
1969), other empirical analyses have found problems with the efficient-market hypothesis. Early
examples include the observation that small neglected stocks and stocks with high book-to-
market (low price-to-book) ratios (value stocks) tended to achieve abnormally high returns
Daniel Kahneman
relative to what could be explained by the CAPM.[33][34] Further tests of portfolio efficiency by
Gibbons, Ross and Shanken (1989) (GJR) led to rejections of the CAPM, although tests of
efficiency inevitably run into the joint hypothesis problem (see Roll's critique).
Following GJR's results and mounting empirical evidence of EMH anomalies, academics began to move away from the CAPM
towards risk factor models such as the Fama-French 3 factor model. These risk factor models are not properly founded on
economic theory (whereas CAPM is founded on Modern Portfolio Theory), but rather, constructed with long-short portfolios in
response to the observed empirical EMH anomalies. For instance, the "small-minus-big" (SMB) factor in the FF3 factor model is
simply a portfolio that holds long positions on small stocks and short positions on large stocks to mimic the risks small stocks
face. These risk factors are said to represent some aspect or dimension of undiversifiable systematic risk which should be
compensated with higher expected returns. Additional popular risk factors include the "HML" value factor (Fama and French,
1993); "MOM" momentum factor (Carhart, 1997); "ILLIQ" liquidity factors (Amihud et al. 2002). See also Robert Haugen.

View of some economists

Economists Matthew Bishop and Michael Green claim that full acceptance of the hypothesis goes against the thinking of Adam
Smith and John Maynard Keynes, who both believed irrational behavior had a real impact on the markets.[42]

Economist John Quiggin has claimed that "Bitcoin is perhaps the finest example of a pure bubble", and that it provides a
conclusive refutation of EMH.[43] While other assets used as currency (such as gold, tobacco) have value independent of people's
willingness to accept them as payment, Quiggin argues that "in the case of Bitcoin there is no source of value whatsoever".

Tshilidzi Marwala surmised that artificial intelligence influences the applicability of the theory of the efficient market hypothesis
in that the more artificial intelligence infused computer traders there are in the markets as traders the more efficient the markets
become.[44][45][46]

Warren Buffett has also argued against EMH, most notably in his 1984 presentation The Superinvestors of Graham-and-
Doddsville, saying the preponderance of value investors among the world's best money managers rebuts the claim of EMH
proponents that luck is the reason some investors appear more successful than others.[47] However, as Malkiel[48] has shown,
over the 30 years prior to 1996 more than two-thirds of professional portfolio managers have been outperformed by the S&P 500
Index and, more to the point, there is little correlation between those who outperform in one year and those who outperform in the
next.

In his book The Reformation in Economics economist and financial analyst Philip Pilkington has argued that the EMH is actually
a tautology masquerading as a theory [49]. He argues that, taken at face value, the theory makes the banal claim that the average
investor will not beat the market average -- which is a tautology. When pressed, proponents will then say that any actual investor
will converge with the average investor given enough time and so no investor will beat the market average. But Pilkington points
out that when proponents of the theory are presented with evidence that a small minority of investor do, in fact, beat the market
over the long-run, these proponents then say that these investors were simply 'lucky'. Pilkington argues that introducing the idea
that anyone who diverges from the theory is simply 'lucky' insulates the theory from falsification and so, drawing on the
philosopher of science and critic of neolcassical economics Hans Albert, Pilkington argues that the theory falls back into being a
tautology or a pseudoscientific construct [50].

Late 2000s financial crisis

The financial crisis of 2007–08 led to renewed scrutiny and criticism of the hypothesis.[51] Market strategist Jeremy Grantham
stated flatly that the EMH was responsible for the current financial crisis, claiming that belief in the hypothesis caused financial
leaders to have a "chronic underestimation of the dangers of asset bubbles breaking".[5] Noted financial journalist Roger
Lowenstein blasted the theory, declaring "The upside of the current Great Recession is that it could drive a stake through the heart
of the academic nostrum known as the efficient-market hypothesis."[6] Former Federal Reserve chairman Paul Volcker chimed in,
saying it's "clear that among the causes of the recent financial crisis was an unjustified faith in rational expectations [and] market
efficiencies."[52] One financial analyst noted "by 2007–2009, you had to be a fanatic to believe in the literal truth of the
EMH."[53]
At the International Organization of Securities Commissions annual conference, held in June 2009, the hypothesis took center
stage. Martin Wolf, the chief economics commentator for the Financial Times, dismissed the hypothesis as being a useless way to
examine how markets function in reality. Paul McCulley, managing director of PIMCO, was less extreme in his criticism, saying
that the hypothesis had not failed, but was "seriously flawed" in its neglect of human nature.[54][55]

The financial crisis led Richard Posner, a prominent judge, University of Chicago law professor, and innovator in the field of Law
and Economics, to back away from the hypothesis. Posner accused some of his Chicago School colleagues of being "asleep at the
switch", saying that "the movement to deregulate the financial industry went too far by exaggerating the resilience—the self
healing powers—of laissez-faire capitalism."[56] Others, such as Fama, said that the hypothesis held up well during the crisis and
that the markets were a casualty of the recession, not the cause of it. Despite this, Fama has conceded that "poorly informed
investors could theoretically lead the market astray" and that stock prices could become "somewhat irrational" as a result.[57]

Efficient markets applied in securities class action litigation

The theory of efficient markets has been practically applied in the field of Securities Class Action Litigation. Efficient market
theory, in conjunction with "fraud-on-the-market theory," has been used in Securities Class Action Litigation to both justify and
as mechanism for the calculation of damages.[58] In the Supreme Court Case, Halliburton v. Erica P. John Fund, U.S. Supreme
Court, No. 13-317, the use of efficient market theory in supporting securities class action litigation was affirmed. Supreme Court
Justice Roberts wrote that "the court’s ruling was consistent with the ruling in "Basic" because it allows "direct evidence when
such evidence is available” instead of relying exclusively on the efficient markets theory."[59]

See also
Adaptive market hypothesis
Financial market efficiency
Dumb agent theory
Index fund
Insider trading
Investment theory
Noisy market hypothesis
Perfect market
Transparency (market)

Notes
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ss/06nocera.html?scp=1&sq=efficient%20market&st=cse). The New York Times. Retrieved 8 June 2009.
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External links
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Proof That Properly Discounted Present Values of Assets Vibrate Randomly (https://ideas.repec.org/a/rje/bellje/v
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