The Myth of Efficient Markets
Efficient Market Hypothesis (EMH) is one of the most fundamental and controversial theories in economics since 1960s. After its conception, EMH turned into a huge success in the academic field of finance and considered as one of the great triumphs of economics. It was very difficult not to be impressed by theoretical arguments for the efficiency of markets. An American economist, Michael C. Jensen, stated in 1978 “there is no other proposition in economics which has more solid empirical evidence supporting it than the efficient-markets hypothesis”. EMH has dominated the stock analysis with its vast array of applications and underpinned many of financial models, e. g. the Black-Scholes Option Pricing Model for calculating the value of the stock options.
EMH and the random walk theory state simply: in an efficient market, prices fully reflect all currently available information and prices adjust to public available new information immediately. According to E. F. Fama, the father of EMH: in an efficient market, on the average, competition will cause the full effects of new information on intrinsic values to be reflected “instantaneously” in actual prices.
Because the Stock and Bond Market is efficient thanks to the tough competition:
- Changes in Price are caused only by new information and therefore Price fluctuations are random and unpredictable.
- Because of random nature of price fluctuations, an average investor cannot beat the market consistently.
- An average investor will be better off if he doesn’t waste his resources on research and analysis on stocks and holds passive index portfolio. The Market knows best.
For the application of EMH in the real world, it’s very important to understand the basic assumptions of this hypothesis. The Fundamentals of the EMH:
- The operating Agents are fully rational.
- The irrational agents affect the market randomly and therefore they cancel each other out.
- The influence of irrational agents causes arbitrage opportunities, which will be immediately eliminated by rational investors. Deviations from equilibrium values could not last for long.
Dependent on efficiency, there are three degrees of EMH:
Weak form efficiency states that evaluating of historical price changes (technical analysis) cannot be used for profit by investors. But the fundamental analysis in contrary can provide opportunities to finding undervalued stocks.
Semi strong form efficiency asserts that neither fundamental nor technical analysis can be used for abnormal returns from the market. Only insider information, which is unavailable to the public, can provide opportunities for investors.
Strong form efficiency implies that even insider information is useless for investors because all kinds of information are reflected in prices.
Evidence for semi strong form of EMH:
After initiation of EMH, Academics gathered a lot of empirical evidence supporting efficient markets. One of the most impressive empirical methodologies was the event studies. These studies investigated the Effects of corporate news on share prices. Fig 1 below shows how share price jumps after the announcement of takeover attempt without any following trend formation. Similar empirical studies have found out that prices don’t change in the absence of information.
Fig. 1: Cumulative Returns of Stock Price of Target Companies in Case of Corporate Takeover Source: ARTHUR J. KEOWN, JOHN M. PINKERTON; 1981; Merger Announcements and Insider Trading Activity: An Empirical Investigation
Critics on EMH:
“Ships will sail around the world but the Flat Earth Society will flourish. There will continue to be wide discrepancies between price and value in the marketplace, and those who read their Graham & Dodd will continue to prosper.” Warren Buffet
“People with knowledge of financial economics may be further surprised that this year Eugene Fama and Robert Shiller are both recipients (of Nobel Memorial Prize in Economics). Prof. Fama made his name by developing the efficient market hypothesis, long the cornerstone of finance theory. Prof. Shiller is the most prominent critic of that hypothesis. It is like awarding the physics prize jointly to Ptolemy for his theory that the Earth is the center of the universe, and to Copernicus for showing it is not.” John Kay
In the last decades, the fundamental assumptions of EMH were challenged by new empirical studies on the psychological weaknesses of investors, especially in the case of uncertainty, incomplete information and noise. Evidence showed that the irrational behavior of people is not random but systematic. And some alternatives to EMH, e. g. behavioral finance has emerged. The financial crisis in 2007 devastated the credibility of the entire academic discipline of finance and fueled the skeptical thoughts like behavioral economics.
If markets are rational, the majority of investors shouldn’t probably trade actively and only use index funds. But they follow the financial gurus, trading advices, technical analysis and they invest in expensive mutual funds. Markets are dominated by noise trading and failure on diversification.
Additional to those “irrational” behaviors of investors, there are also principal – agent problems. Some selected strategies of money managers:
- Minimizing the risk of underperformance by choosing portfolio close to benchmark index
- Stock picking in herd mentality to avoid falling behind
- Window-dressing of end-of-the-year-report: buying recently high performed stocks and selling stocks with poor performance
Those strategies above contradict the assumption of rationality and must create arbitrage opportunities and inefficiencies in the markets.
EMH also neglects the risk of the arbitrage business. If an investor buys an undervalued stock he accepts an estimated risk. Not all people have the same risk attitude. Some people are risk averse and they will create an opportunity for the risk friendly and risk neutral agents. The majority of the money invested in the stock market is owned by big risk averse institutions who manage retirement savings and insurance money. The risk neutral agents can not wipe out them from the market through competition.
One of the important empirical challenges was the Schillers study ‘Do Stock Prices Move Too Much To Be Justified By Subsequent Changes In Dividends?’, which compares the volatility of stock prices and dividends. His conclusion was that volatility of stock prices was far too high to justify the random information as an only significant cause for market fluctuations.
Even J. M. Keynes made the observation that the market agents are biased to overreact: “Day-to-day fluctuations in the profits of existing investments, which are obviously of an ephemeral and non-significant character, tend to have an altogether excessive, and even an absurd, influence on the market.”
According to Keynes, the market was a voting machine as mentioned before and the investors voted not according to their best valuation but to their expectations about how the other investors will vote. He used a beauty contest as an analogy:
“…It is not a case of choosing those which, to the best of one’s judgment, are really the prettiest, nor even those which average opinion genuinely thinks the prettiest. We have reached the third degree where we devote our intelligences to anticipating what average opinion expects average opinion to be. And there are some, I believe, who practice the fourth, fifth, and higher degrees.”
Keynes’ words “anticipating what average opinion expects average opinion to be” means trying to predict the price movements. Some “investors” and traders buy stocks just because their prices are rising and sell stocks just because their prices fall. Therefore, the price movements cause bandwagon effect among traders. This kind of strategies amplifies the price fluctuations and we observe them as an overreaction in the market.
An another empirical challenge comes from De Bondt and Thaler (1985): “Does the Stock Market Overreact?”. In this article, they compared the performance of two portfolios (see fig. 2 below), Loser portfolio and winner portfolio. Those portfolios formed each year since 1933 in relation to their performance over the last 3 years of formation. According to EMH, past performance cannot predict the future performance because the price fluctuations are completely random and therefore, neither of the portfolios should be able to outperform. But as the figure below shows, the loser portfolio outperforms, in violation of Bayes rules – in a non-random manner. The outperformance of loser portfolio indicates that the investors overreact the news and cause high volatility in markets.
The assumptions of EMH that we act rationally in alignment with our own economic self-interest and the competition between investors will eliminate irrational valuation of prices have been tested by some skeptical researchers. The empirical studies have provided a lot of evidence for the irrationality of the investors which is justifiable from the standpoint of human behavior. There are a lot of psychological studies empirically showing that people make systematic errors in their decision making. The conventional economics has difficulty with explaining of those irrational anomalies in the market which led to a need for better more realistic theories.
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