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The Flaws and Implications of the Efficient Market Hypothesis

Second, there is a easy-to-read essay by Malkiel that is well worth your time. I would not really call it a paper on the efficinent market hypothesis, but it does give a usuful survey of work that suggests that it it quite hard for an active manager to do as well as an indexer --- except for the fees he makes, of course.

The efficient market hypothesis refers to aggregated decisions of many market participants.

The Behavioral Challenge to Market Efficiency
According to behavioral finance, none of the above three conditions are likely to hold good in reality.
1. Rationality: Investors are not always rational. Many investors do not achieve the degree of diversification that they should. Most of the investors trade frequently and incur higher brokerage costs and taxes. Actually, taxes can be minimized by selling losers and holding winners. But many investors do just the opposite. The view of behavioral finance is that, not all investors are rational. Thus, the first condition for market efficiency does not hold good in real world.
2. Independent deviations from rationality: Deviations from rationality are not random, thus they are not likely to cancel out in a whole population of investors. It is not uncommon in the market place that investors over value an upcoming new sector like internet, information technology or biotechnology. In these cases, investors believe that current performance of these sectors is representative of the future performance. This behavior of representativeness leads to bubbles in the markets, which is not explained by efficient market hypothesis. On the other hand, there are some conservative investors who are too sluggish to adjust to new information. This results in a slow process of price adjustment to new relevant information. This is against the concept of efficient market hypothesis.
3. Arbitrage: Though, in theory, arbitrage is a risk-less process, in practice it is likely to be more risky. Suppose professional investors generally believe that Tata Motors is under priced. They would buy it, while selling their holding in Maruti Suzuki. However, if amateurs were taking opposite positions, price would adjust to correct level only if the positions of amateurs were small relative to those of the professionals. In a world of many amateurs, a few professionals would have to take big positions to bring prices into equilibrium, perhaps even engaging heavily in short selling. Buying large amount of one stock and short selling large amount of other stock is quite risky, even if the two stocks are in the same industry. Here, unanticipated bad new about Tata Motors and unanticipated good news about Maruti Suzuki would cause professionals to register large losses. Apart from that, even if amateurs did actually misprice Tata Motors and Maruti Suzuki, there is no guarantee that this mispricing would be corrected in short term. This also causes professionals to register losses by liquidating their positions before the equilibrium is established in the prices.
Limits to Arbitrage: Arbitrageurs face practical risks costs while exploiting mispricing and facilitating establishment of equilibrium in prices. The first risk is fundamental risk. This risk exists due to non-existence of perfect substitute stock for mispriced stock. For all practical purposes Maruti Suzuki is not a perfect substitute for Tata Motors even though both the companies operate in the same industry. They differ in terms of sales volume, product profile, management style etc. The second risk is noise trader risk. This is risk that mispricing being exploited by the arbitrageurs worsens in the short run. The possibility of the price of Tata Motors stock going further down and the price of Maruti Suzuki stock going further up due to company specific bad or good news can not be ruled out. Once one has granted the possibility that a security's price can be different from its fundamental value (equilibrium price), one must also grant the possibility that future price movements will increase the divergence between actual value and fundamental value. Noise trader risk forces arbitrageurs to liquidate their positions early, bringing them potentially steep losses. The third limitation of arbitrage process is implementation costs. Transaction costs such as brokerage costs and taxes can make arbitraging less attractive. There are real life examples of how these limitations of arbitrage kill the process of arbitrage.
We have seen in companies like Enron and Worldcom, how managers dupe investors through creative accounting. Firms successfully time their debt and equity issues by issuing equity during bullish equity market and debt during bearish equity markets. Firms do cancel IPOs even just before the opening of the issues, like Wockhardt Hospitals and Emaar MGF, if market conditions change against equity. Firms also defer their IPOs, like ICICI Securities Ltd, due to adverse market for equity offerings. We also have evidences of insider trading, managers and promoters benefitting from inside/private information.
In conclusion, the arguments presented here suggest that the theoretical underpinnings of the efficient capital markets hypothesis might not hold well in reality. That is, investors may be irrational, irrationality may be related across investors rather than cancelling out across investors, and arbitrage strategies may involve too much risk to eliminate market inefficiencies.

The Flaws and Implications of the Efficient Market Hypothesis: ..

Three Pillars of Efficient Market Hypothesis
The necessary conditions for market efficiency are:
1. Rationality: All investors in the market should be rational. When relevant information is released in the market by a firm, all investors will adjust their estimates of stock prices of the firm in a rational way. E.g., the relevant information could be the announcement of new product development by a firm.
2. Independent deviations from rationality: If the relevant information, say the announcement of new product development by a firm is not complete, some investors might get caught up in the romance of a new product development. The announcement by the firm may be incomplete in terms of projected sales, price, cost of the new product and the time it will take for other companies to develop a competing product. Irrational investors may project future sales well above what is rational. They would over pay for the stock and push the prices up. If these investors dominate the market, the stock prices are likely to rise beyond what market efficiency might predict. However, due to emotional resistance, some investors may not react to the incomplete information of new product development. Business historians tell us that investors were initially quite skeptical about the benefits of the telephone, the copier, the automobile, and the motion picture. If investors are primarily pessimistic, the stock price would rise less than market efficiency would predict. If there are equal numbers of optimistic and pessimistic investors in the market, stock prices tend to rise in a manner consistent with market efficiency.
3. Arbitrage: Arbitrage is the process of exploiting situations of over pricing and under pricing of securities. When the some securities are under priced, arbitrageurs (professional investors) buy those stocks which brings the prices to equilibrium and simultaneously sell over priced substitute securities. Thus, at any point of time the securities will be correctly priced.
If any one of the above three conditions is satisfied in reality, market efficiency is maintained.

The concept of 'efficient market hypothesis' was introduced by Eugene Fama in mid-1960s. According to this concept, the intense competition in the capital market leads to fair pricing of debt and equity securities. The concept is based on the reflection of relevant information in market prices of the securities. If only past information is reflected in 'weak-from efficient markets; past as well as present information is reflected in 'semi-strong form efficient markets'; past, present, and future information is reflected in 'strong-form efficient markets'.
Efficient market hypothesis has profound implications for corporate finance and investment management.
Implications for corporate finance
1. Managers cannot fool the market through creative accounting.
2. Firms cannot successfully time issues of debt and equity.
3. Managers cannot profitably speculate in securities market.
4. Managers can reap benefits by paying attention to market prices.
Implications for investment management
1. If the market is efficient in weak-form, investors can not obtain abnormal returns by analyzing relevant historical information about the securities. However, it is possible to obtain abnormal returns by analyzing current information and future information. Thus, investment tools like filter strategy, technical analysis will not be effective. Fundamental analysis will be an effective approach for investment management.
2. If the market is efficient in semi-strong form, analysis of relevant historical and current information is of no use for gaining abnormal returns. Only access to future information will give abnormal returns. Thus, filter strategy, technical analysis, and fundamental analysis will not be effective for investment management.
3. If the market is efficient in strong-form, analysis of past, present, and future information is of no use to gain abnormal returns. Random selection of the stocks based on defined returns or risk will be the best approach for investment. Portfolio investment will be the only way to maximize returns for given level of risk or minimize risk for given level of returns.

QUESTION 1 An implication of the efficient markets is that _____

The concept of Efficient Market Hypothesis has weak foundations. The effectiveness of these hypothesis depends upon validity of one of the three conditions viz. rational investment decisions, independent irrational investment decisions, and arbitrage. In practice, none of these three conditions are valid. An alternative approach, to explain capital market behavior, based on psychology is gaining importance in the field of finance.

There is no such thing as a free lunch. Long-Term Capital Management (LTCM) came unstuck in 1998, as described in Chapter Two, for believing that it could profitably trade market inefficiencies on the assumption that there would always be a return to equilibrium. Those claiming consistently above-normal returns, whether they were fraudsters such as Bernie Madoff or investment banks claiming to have uncovered news ways of generating high-yielding returns in a low-yield world. The efficient market hypothesis should have told regulators there was something suspicious about this. If they were hung up on an extreme, unrealistic and wrong version of the hypothesis – the markets are always right, both now and in what they imply for the future – more fool them. If Wall Street’s ricket scientists fell into a similar trap, then they were a lot less intelligent than they thought they were. The efficient market hypothesis, interpreted correctly, was unfairly castigated.

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Implications of efficient market hypothesis - Experts …

If economic models failed during the crisis, so according to some of the most vocal critics, did something else central to the macroeconomic and regulatory framework in the period leading up to the crisis. This was the efficient market hypothesis, versions of which had been around for most of the 20th century but which was best defined by Professor Eugene Fama of Chicago University, in a seminal 1970 article, ‘Efficient Capital Markets: A Review of Theory and Empirical Work’, published in the Journal of Finance. Fama’s central concept was very simple, which was that financial markets are efficient in the sense that the price of, say, a company’s stock, reflects all the known information at the time.

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