Abstract
Efficient Market Hypothesis developed by Eugene Fama in1969 states that security prices reflect all available information. This idea has been applied to various theories and models to determine if predictability of future profits and prices can be achieved. There are critics of EMH who believe investors act in an irrational way and also test to coincide with the critic's theory of inefficiency.
Introduction
This essay argues about the Efficient Market Hypothesis (EMH) concept and importance. I will start by discussing the ideas behind EMH and how it is linked with the concept of random walk and what characteristics markets must have to be considered as efficient. Following this, will be the different levels of market efficiency, the stock market anomalies of EMH and finally, the implications and importance of EMH for investors. The concept of efficient market hypothesis is concerned with the behaviour of stock and commodity price (Brealey and Myers, 2003). The term EMH became well-known by Eugene Fama (1969) who defined it as when 'security prices fully reflect all available information'.
Main essay
According to Fama a market is considered efficient if it possess these following characteristics a)"all security prices fully reflect all know market information and b) no traders in the market have monopoly control of information" (Schwartz 1969:421). It is only new information that can bring about price changes and majority of the information received is unpredictable therefore making it hard to predict future price changes (Arnold, 2002).
In 21st century market, it is easy for investors and financial personnel's to receive and react to information quickly with the growing technological means of communication such as social network. If stocks are not priced correctly this allows investors to find a gap in the market to make extra profit which coincides with the characteristics of an efficient market that is the maximisation of profits and this relates to Arnold (2002:604) who explains that "In an efficient market the moment an unexpected, positive piece of information leaks out investors will act and prices will rise rapidly to a level which gives no opportunity to make further profit".
The price of stocks and commodities seem to follow a random walk which means that the past changes of stock price cannot be used to predict future price changes therefore making it hard for investors to predict their rate of return. The idea of random walk was presented by Maurice Kendall (1953) who described it as "one day's price change cannot be predicted by looking at previous day's price change" (Arnold, 2002:608). A random walk happens because stock price reflects all available information and it is only new information that causes price changes (Arnold, 2002). The random model is consistent with EMH because it is linked with the weak form of EMH which states past stock price contains no information about future changes. Random walk model is valid only if trends of past stock prices cannot be used to increase ordinary rate of return.
Efficient markets can be classified into three levels of efficiency based on the information reflected in share prices. First level is the weak-form hypothesis which states that share prices reflect information that is contained in past price changes (Arnold, 2002), while the second level is the semi-strong form efficiency which is similar to the weak form apart from the fact that this also includes other public information(e.g. financial statements), and the last level is the strong-form efficiency which states that share prices reflects all available information including both public and private information e.g. company analysis which is normally used by board directors (Arnold, 2002).
With the weak form hypothesis, investors will see that they cannot make extraordinary profits because prices follow a random walk as technical analyst believe using charts and trends of past share prices to predict future price changes but in the weak form no chance for the technical analyst because the future cannot be predicted using past share prices. In the weak form historic past share prices does not produce useful information for the investors that will help them yield extra returns so therefore it must mean the market is efficient (Schwartz, 1970). The weak form has been much debated from the chartist theories and the theory of random walk which is commonly known as random walk hypothesis because it maintains that share prices move in a random manner.
The chartist is the same as technical analyst who assume that the use of patterns from past price changes will always repeat in the future and through careful examination can be used to make excess return than the average expected market return (Fama, 1965). Fama (1965:34) simply puts the concept of random theory in the weak form as "the series of price changes has no memory, that is, the past cannot be used to predict the future in any meaningful way". There are various tests that can be used on the weak form such as the filter approach founded by Sidney Alexander which states that a "filter level has to be defined thus leading onto the application method" as described by Arnold (2002:612) as "if the share under observation rises by more than the defined level then investors are advised to buy and hold but if the shares fall from a high more than defined level then investors should sell and go short". The buy and hold approach is more favoured than chartist method because it is long term allowing the market to grow which in a few years can yield good returns whereas the chartist approach is subjective judgement so therefore good rate of return is not guaranteed.
Semi-strong form states that "prices reflect all relevant information that is publicly available" (Dimson and Mussavian, 1998:4) and these public information include stock splits, dividends, earnings etc. Fundamental analysis is associated with the semi strong form in that they try to "estimate the intrinsic value of a share by gathering and evaluating as much relevant information as possible e.g. company accounts and announcements, tax rates etc. " (Arnold,2002:615). Once a value for the share has been determined it is then compared to the market price, furthermore it can then be evaluated whether it is overpriced or under-priced (Arnold, 2002). The main objective of fundamental analyst is to predict future profit but the semi strong form discredits this because all public information is reflected in the share price which means they cannot make abnormal returns. There have been various tests for the semi strong form but the main one is the event study which is an analysis of the impact an event (stock splits or announcement of dividends) or information will have on a firms share price. According to Fama (1969:404) "each individual test, however, is concerned with the adjustment of security prices to one kind of information generating event". Before an event occurs (stock split), the stocks earned a higher return than the average market return (Fama et al.,1969), therefore it is wise to say that "the market appears to anticipate the information, and most of the price adjustment is complete before the event is revealed to the market" (Dimson and Mussavian, 1998:95).
Last form of efficiency is the strong form which states that all information whether public or private is reflected in the share price meaning that abnormal profits cannot be made. To test efficiency in the strong form I shall look at the company insiders (have access to private information) and fund managers. Fama (1969:398) discusses how the company insider test does not support the strong form because "the specialist has monopoly power over an important block of information, and not unexpectedly, uses his monopoly to turn a profit", thus meaning that it is possible for some to make abnormal profit through having information not publicly available. Michael Jenson looked at the concept of fund managers where he found that "mutual fund managers in general do not seem to have access to information not already fully reflected in price" (Fama, 1969:413), this shows support for the strong form efficiency because managers cannot generate returns that beat the current market return.
Stock market anomalies
Various studies have been carried out to show that there are anomalies in the EMH meaning that investors can earn abnormal return in excess of the market. Dissanaike (1997) looks at the inefficiencies in weak form using the overreaction hypothesis where investor overreact to bad or good news which leads investors being able to predict future prices (Arnold,2002). De Bondt and Thaler conducted a test which proved that shares that had fallen over previous years exceeded the average market return than shares that had done better over previous years (Dimson and Mussavian, 1998). There are also cases of market inefficiency in the semi-strong form but I shall briefly discuss the size and January effect. The size effect conducted by Banz (1981) found that "50 smallest stocks outperformed the 50 largest by an average of 1% per month, on a risk-adjusted basis" (Dimson and Mussavian, 1998:97) which links to the January effect because the outperformance of smallest stock happens in the month of January. The problem with relying on the January effect is that "investors will buy in anticipation of the January effect and so cause the market to already be at the new higher level on January 1" thus losing reason for investing in it the first place (Arnold,2002:617). The strong form can also be classified as inefficient because it allows company insider to make abnormal profits.
Implications of EMH for investors
Investors should believe that the market is efficient most of the time and that security price reflect all information so therefore it is very difficult or nearly impossible to get abnormal returns. There implications of an efficient market for an investor.
Trust Market Prices because the security prices reflect all available information in the market (Brealey and Myers, 2003). This means that it is impossible investors to make abnormal profit and predict future prices.
Read into prices because "security prices can tell investors a lot about the future" (Brealey and Myers, 2003:365), thus able to make reasonable and informative decisions.
Investors need to press for greater volume of information because if people like the government release valuable and timely information this can prevent possibility of insiders getting abnormal profits using private information (Arnold.2002).
Conclusion
The concept of EMH is concerned with whether the market is efficient meaning all available information is reflected in the security prices and it can be said that the market is efficient but not perfectly efficient. I have examined three categories to determine how efficient the market is, weak form which is using charts and historical data, semi-strong involves using all information that is publicly available and strong form which looks at whether company insiders have access to private information. The concept of Random Walk is what makes the market efficient because if information comes in a random and unbiased way it makes it hard for profit and shares prices to be predicted. The weak and semi-strong form both support the EMH theory because it prevents any possibility to make profits above the average market return while on the other hand the strong form creates a possibility for abnormal profit to be from those with inside information. It would be totally wrong to disregard the use of charts and historical data because it can be used to help make useful decisions about a company's performance and also predict future profits but in the short run. . The strong form fails to hold because of the legislation on insider trading in the UK which tries to prevent one from making abnormal profits but this law can be contested. With the growing rate of technology it means companies can gain access to a large pool of information allowing for an opportunity to beat the market and also information can be adjusted to security prices more quickly. If the market was efficient then the rate of return should equal to the average market return but in reality there are people like Warren Buffett who is richer than most investors, thus meaning of EMH is not wholly efficient and people can beat the market to make excess returns.
