Efficient-market hypothesis
The efficient-market hypothesis is a hypothesis in financial economics that states that asset prices 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.
Because the EMH is formulated in terms of risk adjustment, it only makes testable predictions when coupled with a particular model of risk.
As a result, research in financial economics since at least the 1990s has focused on market anomalies, that is, deviations from specific models of risk.
The idea that financial market returns are difficult to predict goes back to Bachelier, Mandelbrot, and Samuelson, but is closely associated with Eugene Fama, in part due to his influential 1970 review of the theoretical and empirical research.
The EMH provides the basic logic for modern risk-based theories of asset prices, and frameworks such as consumption-based asset pricing and intermediary asset pricing can be thought of as the combination of a model of risk with the EMH.
Theoretical background
Suppose that a piece of information about the value of a stock is widely available to investors.If the price of the stock does not already reflect that information, then investors can trade on it, thereby moving the price until the information is no longer useful for trading.
Note that this thought experiment does not necessarily imply that stock prices are unpredictable.
For example, suppose that the piece of information in question says that a financial crisis is likely to come soon.
Investors typically do not like to hold stocks during a financial crisis, and thus investors may sell stocks until the price drops enough so that the expected return compensates for this risk.
How efficient markets are linked to the random walk theory can be described through the fundamental theorem of asset pricing.
This theorem provides mathematical predictions regarding the price of a stock, assuming that there is no arbitrage, that is, assuming that there is no risk-free way to trade profitably.
Formally, if arbitrage is impossible, then the theorem predicts that the price of a stock is the discounted value of its future price and dividend:
where is the expected value given information at time, is the stochastic discount factor, and is the dividend the stock pays next period.
Note that this equation does not generally imply a random walk.
However, if we assume the stochastic discount factor is constant and the time interval is short enough so that no dividend is being paid, we have
Taking logs and assuming that the Jensen's inequality term is negligible, we have
which implies that the log of stock prices follows a random walk.
Although the concept of an efficient market is similar to the assumption that stock prices follow:
which follows a martingale, the EMH does not always assume that stocks follow a martingale.
Empirical studies
Research by Alfred Cowles in the 1930s and 1940s suggested that professional investors were in general unable to outperform the market.During the 1930s-1950s empirical studies focused on time-series properties, and found that US stock prices and related financial series followed a random walk model in the short-term.
While 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.
In their seminal paper, propose the event study methodology and show that stock prices on average react before a stock split, but have no movement afterwards.
Weak, semi-strong, and strong-form tests
In Fama's influential 1970 review paper, he categorized empirical tests of efficiency into "weak-form", "semi-strong-form", and "strong-form" tests.These categories of tests refer to the information set used in the statement "prices reflect all available information."
Weak-form tests study the information contained in historical prices.
Semi-strong form tests study information which is publicly available.
Strong-form tests regard private information.
Historical background
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.It has been speculated that Bachelier drew ideas from the random walk model of Jules Regnault, but Bachelier did not cite him, and Bachelier's thesis is now considered pioneering in the field of financial mathematics.
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, which was cited by mathematicians including Joseph L. Doob, William Feller and Andrey Kolmogorov.
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.
The concept of market efficiency had been anticipated at the beginning of the century in the dissertation submitted by Bachelier to the Sorbonne for his PhD in mathematics.
In his opening paragraph, Bachelier recognizes that "past, present and even discounted future events are reflected in market price, but often show no apparent relation to price changes".
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 in his article The Use of Knowledge in Society 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.
Early theories posited that predicting stock prices is unfeasible, as they depend on fresh information or news rather than existing or historical prices.
Therefore, stock prices are thought to fluctuate randomly, and their predictability is believed to be no better than a 50% accuracy rate.
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.
In 1965, Eugene Fama published his dissertation arguing for the random walk hypothesis.
Also, Samuelson published a proof showing that if the market is efficient, prices will exhibit random-walk behavior.
This is often cited in support of the efficient-market theory, by the method of affirming the consequent, however in that same paper, Samuelson warns against such backward reasoning, saying "From a nonempirical base of axioms you never get empirical results."
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.
Criticism
Investors, including the likes of Warren Buffett, George Soros, 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.
Empirical evidence has been mixed, but has generally not supported strong forms of the efficient-market hypothesis.
According to Dreman and Berry, in a 1995 paper, low P/E stocks have greater returns.
In an earlier paper, Dreman also refuted the assertion by Ray Ball that these higher returns could be attributed to higher beta leading to a failure to correctly risk-adjust returns; Dreman's research had been accepted by efficient market theorists as explaining the anomaly in neat accordance with modern portfolio theory.
Behavioral psychology
Behavioral psychology approaches to stock market trading are among some of the alternatives to EMH.However, 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 behavioral finance is that individuals employ hyperbolic discounting.
It is demonstrably true that bonds, mortgages, annuities and other similar obligations 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 of individuals underscored by behavioral finance.
On the other hand, economists, behavioral 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 2008 financial crisis.
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 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.
The performance of stock markets is correlated with the amount of sunshine in the city where the main exchange is located.