Efficient- share market hypothesis

In the efficient-market hypothesis (EMH) asserts that financial markets are "informationally efficient", or that prices on traded assets (e.g., stocks, bonds, or property) already reflect all known information, and rapidly change to reflect new information. Therefore it is impossible to consistently outperform the market by using any information that the market already knows, except through luck. Information or news in the EMH is defined as anything that may affect prices that is unknowable in the present and thus appears randomly in the future.

Historical background

The efficient-market hypothesis was developed by Professor at the as an academic concept of study through his published Ph.D. thesis in the early 1960s at the same school. It was widely accepted up until the 1990s, when economists, who were a fringe element, became mainstream.Empirical analyses have consistently found problems with the efficient markets hypothesis, the most consistent being that stocks with low price to earnings (and similarly, low price to cash-flow or book value) outperform other stocks.Alternative theories have proposed that cause these inefficiencies, leading investors to purchase rather Although the efficient markets hypothesis has become controversial because substantial and lasting inefficiencies are observed, Beechey et. al. (2000) consider that it remains a worthwhile starting point.
The efficient-market hypothesis was first expressed by , a French mathematician, in his 1900 dissertation, "The Theory of Speculation". His work was largely ignored until the 1950s; however beginning in the 30s scattered, independent work corroborated his thesis. A small number of studies indicated that US stock prices and related financial series followed a .Research by in the ’30s and ’40s suggested that professional investors were in general unable to outperform the market.
The efficient-market hypothesis emerged as a prominent theory in the mid-1960s. 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.In 1965 Eugene Fama published his dissertation arguing for the random walk hypothesis,and Samuelson published a proof for a version of the efficient-market hypothesi.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 weak, semi-strong and strong (see below).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. 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. A study on stocks response to dividend cuts or increases over three years found that after an announcement of a dividend cut, stocks underperformed the market by 15.3% for the three-year period, while stocks outperformed 24.8% for the three years afterward after a dividend increase announcement.

Theoretical background

Beyond the normal maximizing agents, the efficient-market hypothesis requires that agents have 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 have different implications for how markets work.
In weak-form efficiency, future prices cannot be predicted by analyzing price from the past. Excess returns can not be earned in the long run by using investment strategies based on historical share prices or other historical data. techniques will not be able to consistently produce excess returns, though some forms of 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 . The 2007 could be cited as evidence. For while the use of very sophisticated models of the market was able to accrue profits from the existence of small anomalies in the market since their general adoption by hedge funds, brokers and investment banks early in this century, the current downturn has seemingly stymied all of these models and, moreover, has wiped out such 'profits' going back over a dozen years. However, while EMH predicts that all price movement (in the absence of change in fundamental information) is random (i.e., non-trending), many studies have shown a marked tendency for the stock markets to trend over time periods of weeks or longerand 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 in appearance). Various explanations for such large and apparently non-random price movements have been promulgated. But the best explanation seems to be that the distribution of stock market prices is in which case EMH, in any of its current forms, would not be strictly applicable
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 nor 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.
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 and behavioral finance

Price-Earnings ratios as a predictor of twenty-year returns based upon the plot by The horizontal axis shows the as computed in Irrational Exuberance (inflation adjusted price divided by the prior ten-year mean of inflation-adjusted earnings). The vertical axis shows the geometric average real annual return on investing in the S&P Composite Stock Price Index, reinvesting dividends, and selling twenty years later. Data from different twenty-year periods is color-coded as shown in the key. See . Shiller states "confirms that long-term investors—investors who commit their money to an investment for ten full years—did do well when prices were low relative to earnings at the beginning of the ten years. Long-term investors would be well advised, individually, to lower their exposure to the stock market when it is high, as it has been recently, and get into the market when it is low."This correlation between price to earnings ratios and long-term returns is not explained by the efficient-market hypothesis.
Investors and researchers have disputed the efficient-market hypothesis both empirically and theoretically. attribute the imperfections in financial markets to a combination of such as overreaction, representative bias, an inability to use rather than linear reasoning, and various other predictable human errors in reasoning and information processing. These have been researched by psychologists such as These errors in reasoning lead most investors to avoid high-value stocks and buy at expensive prices, which allow those who reason correctly to profit from bargains in and the selling of growth stocks.
Empirical evidence has been mixed, but has generally not supported strong forms of the efficient markets hypothesisAccording to Dreman, in a 1995 paper, low P/E stocks have greater returns.In an earlier paper he 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 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 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 are an obvious anomaly, in that the market often appears to be driven by buyers operating on , 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 irrational bubbles because, as , "Markets can remain irrational longer than you can remain solvent."Sudden market crashes as happened on are mysterious from the perspective of efficient markets, but allowed as a rare statistical event under the Weak-form of EMH.
a well-known proponent of the general validity of EMH, has warned that certain emerging markets such as are not empirically efficient; that the and markets, unlike markets in United States, exhibit considerable serial correlation non-random walk, and evidence of manipulation.
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——announced his skepticism of investors beating the market: "They're [investors] just not going to do it [beat the market]. It's just not going to happen."has started a fund based on his research on cognitive biases. In a 2008 report he identified and the as central .

Popular reception

Despite the best efforts of EMH proponents such as , whose book achieved best-seller status, the EMH has not caught the public's imagination. Popular books and articles promoting various forms of , such as the books by commentator and former fund manager , have continued to press the more appealing notion that investors can "beat the market."
Many believe that EMH says that a security's price is a correct representation of the value of that business, as calculated by what the business's future returns will actually be. In other words, they believe that EMH says a stock's price correctly predicts the underlying company's future results. Since stock prices clearly do not reflect company future results in many cases, many people reject EMH as clearly wrong.
However, EMH makes no such statement. Rather, it says that a stock's price represents an aggregation of the probabilities of all future outcomes for the company, based on the best information available at the time. Whether that information turns out to have been correct is not something required by EMH. Put another way, EMH does not require a stock's price to reflect a company's future performance, just the best possible estimate or forecast of future performance that can be made with publicly available information. That estimate may still be grossly wrong without violating EMH.
Further empirical work has since 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 does not know if a model correctly stipulates the required rate of return. Consequently, a situation arises where either the asset pricing model is incorrect or the market is inefficient, but one has no way of knowing which is the case.