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Efficient Market Hypothesis - EMH - Investopedia
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 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.
EFFICIENT MARKET HYPOTHESIS | Ruth Badru - …
In its strongest form, the EMH says a market is efficient if all information relevant to the value of a share, whether or not generally available to existing or potential investors, is quickly and accurately reflected in the market price. For example, if the current market price is lower than the value justified by some piece of held information, the holders of that information will exploit the pricing anomaly by buying the shares. They will continue doing so until this excess demand for the shares has driven the price up to the level supported by their private information. At this point they will have no incentive to continue buying, so they will withdraw from the market and the price will stabilise at this new equilibrium level. This is called the of the EMH. It is the most satisfying and compelling form of EMH in a theoretical sense, but it suffers from one big drawback in practice. It is difficult to confirm empirically, as the necessary research would be unlikely to win the cooperation of the relevant section of the financial community – insider dealers.
An ‘efficient’ market is defined as a market where there are large numbers of rational, profit ‘maximisers’ actively competing, with each trying to predict future market values of individual securities, and where important current information is almost freely available to all participants. In an efficient market, competition among the many intelligent participants leads to a situation where, at any point in time, actual prices of individual securities already reflect the effects of information based both on events that have already occurred and on events which, as of now, the market expects to take place in the future. In other words, in an efficient market at any point in time the actual price of a security will be a good estimate of its intrinsic value.
3 The Efficient Markets Hypothesis ..
The intellectual dominance of the efficient-market revolution has more been challenged by economists who stress psychological and behaviorial elements of stock-price determination and by econometricians who argue that stock returns are, to a considerable extent, predictable.
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.
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Femina PDF | Efficient Market Hypothesis | Financial …
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efficient market hypothesis EMH, ..
For about ten years after publication of Fama's classic exposition in 1970, the Efficient Markets Hypothesis dominated the academic and business scene. A steady stream of studies and articles, both theoretical and empirical in approach, almost unanimously tended to back up the findings of EMH. As Jensen (1978) wrote: ‘There is no other proposition in economics which has more solid empirical evidence supporting it than the EMH.’
Efficient-market hypothesis - Wikipedia
If a market is strong-form efficient, the current market price is the best available unbiased predictor of a fair price, having regard to all relevant information, whether the information is in the public domain or not. As we have seen, this implies that excess returns cannot consistently be achieved even by trading on inside information. This does prompt the interesting observation that must be the first to trade on the inside information and hence make an excess return. Attractive as this line of reasoning may be in theory, it is unfortunately well-nigh impossible to test it in practice with any degree of academic rigour.
That Time Buffett Smashed the Efficient Market Hypothesis
If a market is semi-strong efficient, the current market price is the best available unbiased predictor of a fair price, having regard to all publicly available information about the risk and return of an investment. The study of public information (and not just past prices) cannot yield consistent excess returns. This is a somewhat more controversial conclusion than that of the weak-form EMH, because it means that analysis – the systematic study of companies, sectors and the economy at large – cannot produce consistently higher returns than are justified by the risks involved. Such a finding calls into question the relevance and value of a large sector of the financial services industry, namely investment research and analysis.
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