Modern financial theory's cornerstone belief is that markets are efficient but in practice that is not the case. The efficient markets hypothesis states that investors are not capable of performing above the market, because the price of a stock, bond, and other assets reflect all the information that is relevant and pertinent. Consequently, all financial instruments trade at their fair value which Investopedia defines as, meaning that are no discounts for premiums in the market. However, recent data and events in global markets suggest that in reality the markets are inefficient, and investors are capable of beating the market consistently over long periods of time. Investors like Warren Buffet have in fact beaten the market over long periods of time. During market crashes such as the 2008 or the dotcom bubble of 2001 stocks were clearly deviating from their fair values and yet to the supporters of the theory have yet come up with an explanation as to what changed, information wise, during that particular event. In reality markets do not behave as theory suggests but in fact other factors must be taken into account: i.e. human behavior or information inefficiency. Traditional finance paradigms have yet to explain the behavior of markets during bubbles and times of uncertainty, even when there is no change in the fundamentals of a stock the price may plummet or rise. The same principle is applicable to commodities and the foreign exchange market.
With the importance of global financial markets in the functioning of the world's economy financial theorists and practitioners must move away from an antiquated theory and embrace emerging new paradigms in finance
Part II
For the purposes of this paper I must answer several questions regarding efficient markets such as: What is the efficient markets theory? What causes markets to be inefficient? How is human psychology involved? What are the alternatives to efficient market theory? Who are its main supporters and detractors? Is there evidence to prove that markets are inefficient? Are there case studies of inefficient markets? Can individual investors beat the market? Do all investors have access to the same information about an asset? Is there an information asymmetry? How could this be corrected?
Part III
In order to establish the theoretical framework for this paper a better definition of the efficient market hypothesis should be presented. The first source used is Andrew W. Lo's article "Efficient Market Hypothesis". In this article Lo surveys the main tenets of the hypothesis along with the main authors on the subject. Additionally Lo also presents the contrasting views on the theory. The efficient markets theory 'herein referred to as EMH' was the work of two economists in the 1960's who despite having different research interests arrived at similar conclusions through different paths. Paul Samuelson's input as came as the result of his interest in "temporal pricing models of storable commodities that are harvested and subject to decay" (Lo). On his article titled "Proof that Property Anticipated Prices fluctuate Randomly" according to Lo, Samuelson summarized the idea of EMH as " in an informationally efficient market price changes must be unforecastable if they are properly anticipated, that is, if they fully incorporate the information and expectations of all market participants" (Lo). On the other hand, Fama's contribution to EMH came as a result of research interested in examining statistical properties of stock prices. The aim of his analysis was to settle an academic debate over the use of technical analysis (using charts to determine future movements of stock prices) and the use of fundamental analysis-using accounting information to determine the fair value of a stock. Fama provided a better definition of the EMH: prices fully reflect all available information. Lo argues that investors attack even the minutest informational advantages in order to make profits but engaging in such behavior, results in an elimination of profit opportunities. The EMH, Lo writes, branched into many directions. It is important to note that among the theories encompassing the EMH are: random walk hypothesis, variance bounds tests and others. Finally Lo concludes as saying "Samuelson has suggested, financial economics is the crown jewel of the social sciences, then the EMH must account for half the facets" (Lo). It is important to note that EMH constitutes an important part of financial theory and despite its being challenged, its importance must be recognized and Lo does that.
In the remaining of the article Lo discusses the arguments of why markets are not efficiently. He cites the research of Grossman and Stieglitz, famed economists that researched market efficiency and rationality, discussing the fact that the EMH assumed that investors behave in a rational matter and that Fama and Samuelson did not take into account behavioral aspects of investors. This article provided an important introduction to the subject of efficient market hypothesis.
Dimson and Mussavian in their paper titled "Market Efficiency" further discuss the history of the EMH but they provide a different outlook than Lo. In their article they cite the origins of the EMH in Bachelier's Ph.D dissertation in mathematics in the 1900's "past, present and even discounted future events are reflected in market price, but often show no apparent relation to price changes" (qtd. in Dimson and Mussavian). The markets show two types of efficiency weak or strong. In the weak form of EMH prices fully reflect a sequence of past prices. In the semi strong-form, all prices reflect the publically available information and finally in the strong-form that information is known to any participant in the market. Dimson and Mussavian state that studies have shown that those investors who act on privileged information are capable of achieving excess returns and effectively violate the strong form of EMH. Studies conducted by Cowles show that professional investors are not capable of beating the market consistently. In this respect Jensen conducted a series of experiments and as he so eloquently discusses "on average the funds apparently were not quite successful enough in their trading activities to recoup even their brokerage expenses" (qtd. in Dimson and Mussavian). The experiment was conducted among 115 mutual funds from 1955-1964. Fama conducted further studies in mutual funds and arrived at a similar conclusion as Jensen. This paper is relevant to the research because it goes a step further into the EMH and provides us with an effective introduction to more detailed explanation of the EMH and the different theoretical forms. The article helps to further answer the question of what market hypothesis is and thus the paper may now examine the controversies among academics and practitioners regarding the validity of the EHM. We have explored the main basis for a study on EMH now it is appropriate to present further theories that are pertinent to the subject matter as well as evidence on market inefficiency.
One of the tenets of the efficient market hypothesis is the belief that investors behave rationally; however, in reality investors behave irrationally. The article by Julia Hanna presents the notion that investors don't behave as coldly as a computer model and for example investors may hold onto shares in unwanted stock because they fail to act out of inertia (Hanna). Investors, as Hanna says, might not act in their best interest when the time arrives to liquidate positions in their investment portfolio. Hanna provides an example of a company that was acquired by another and all of a sudden the investor found himself with shares of a company that he never intended on buying; logically the investor would sell those shares but in irrational behavior takes over and people hold onto those positions. In academic finance and economics it is believed that since investors act rationally, market prices reflect the fair value of the asset and investors respond to changes in predictable ways. Yet as Malcolm Baker a researcher at Harvard writes "investors don't act like computers in financial models. Behavioral finance replaces these idealized decision makers with real and imperfect people who have social, cognitive, and emotional biases" (qtd. in Hanna). The implications of irrational behavior among investors has consequences in the markets since they keep prices artificially inflated-the investor holding onto the shares he never "intended" on buying. The market inefficiency is a direct result of the decisions that investors are taking based on behavioral patterns. Hanna writes that it is beneficial to understand investor psychology and to formulate responses to that behavior; additionally Hanna states that there are opportunities for profits by taking advantage of the irrational behavior of some investors and companies may even benefit by finding alternatives to reduce their cost of capital. However, Hanna also states that irrational behavior is very adaptive and it changes depending on our interaction with the surrounding environment "our biases come from the innate, quick, and mostly unconscious decisions that enable us to function effectively in our day-to-day lives" (Hanna).
The article presents a solid refute to the principle rationally within the EMH. In the real world the situation explained the article takes place with varying degrees of frequency and some savvy investors are capable of exploiting those inefficiencies in the market and make significant amounts of profit. The EHM, as evidenced by this article, does not paint the whole picture of the market but more of an idealistic, quasi utopia of financial markets. In succeeding paragraphs will examine empirical evidence which refutes the EMH.
Phillip S. Russel and Violet M. Torbey, professors at Philadelphia University and Bond University respectively, present evidence against the efficient market hypothesis. Among the criticisms they identify are: the January effect, the weekend effect, other seasonal effects, the small firm effect, P/E ratio effect, value-line enigma effect, over and under value of stock prices to earnings announcements, S&P 500 Index effect, price of close-end funds, and even the weather. Russel and Torbey state that "EMH became controversial especially after the detection of certain anomalies in the capital markets" (Russel and Torbey) and this has led to a growing discontent with the EHM. The research also discusses other variables that cause the markets to be inefficient such as noise trading, trend following and volatility tests. Russel and Torbey state that in the market there are essentially two types of investors: rational speculators who make trades based on information and noise traders who "trade on the basis of imperfect information" (Russel and Torbey) and it is this type of trader who causes the market prices to stray away from their fair value as proposed by the EHM. Despite the fact that rational speculators correct to some degree the diversion created by noise traders, they do not eliminate deviations completely. They describe noise traders as people that are guided by everything else but "rational evaluation of information" (Russel and Torbey) but at the same time those noise traders provide liquidity to the market and informed traders take advantage of this. As long as there is enough risk premiums and limited arbitrage, both authors claim that it is not foreseeable that the market would eliminate noise traders and keep efficient prices in the market. Additionally the article presents criticisms to the EMH from a Keynesian perspective. According to the EMH: investors tend to have a long-term view but they behave in short-term horizons, meaning that they are seeking profits quickly and that there is a tendency among investors to follow the herd rather than their own instinct, as Keynes puts it "the goal of the investor is often to pick the girl that others would consider prettiest rather than choosing the one he/she thinks is prettiest" (qtd. in Russel and Torbey). The observation of Keynes despite being made in the markets of 1930 is still very true in the modern markets: markets are composed of speculators and investing according to Keynes becomes a type of musical chair game, in which only those who are paying attention the music and are aware of others around them may eventually win.
The authors of the article provided further evidence that the markets are not efficient. The anomalies they present are all based on perceptions of investors in a given period of time and are not necessarily a reflection of a change in information. Also it is important for the reader to distinguish the different types of investors in the market in order to understand that the prices in the market are driven mostly by people who haven't got a clue of what they are doing and are following the behavior or rational speculators, but by doing so they create inefficient markets. However, those noise traders are a necessary evil in the market because without their behavior, rational speculators would not be able to make excess returns in comparison to the market. Academic textbooks as we will examine in the next section also highlight the fallacy of efficient markets.
Gitman in his book "Introduction to Managerial Finance" presents interesting evidence against the EMH which were discussed in previous paragraphs. Previously some market abnormalities were including January effect, small-firm effect, and others; however, they were not explained and in order to provide support for the thesis that markets are inefficient. It is pertinent to define them in as concise a manner as Gitman does. In the appendix to Chapter 7 Gitman explains the small-firm effect and the January effect. The small-firm effect is a consequence of the abnormal returns of small firms over long periods of time, despite being considerably riskier than large capitalization firms. Gitman proposes that the small-firm has diminished in recent years but still remains a valid argument against the EMH. The small-firm effect, according to Gitman, may be the result of "rebalancing of portfolios by institutional investors, tax issues, low liquidity of small-firm stocks, large information costs in evaluating small firms, or an inappropriate measurement of risk for small-firm stocks" (Gitman).
Another effect that Gitman examines as evidence against the EMH is the January effect which basically is inflation in stock prices from December to January and it is then used as a barometer to predict the behavior of the market in the remaining eleven months of the year. The effect Gitman says may be the result of various factors such as tax factors. As Gitman explains "Investors have an incentive to sell stocks before the end of the year in December, because they can then take capital losses on their tax return and reduce their tax liability" (Gitman), and then in January buy those same stocks again and driving up the prices artificially since there was no real change in information or events that would significantly alter the functioning of the markets.
Gitman's work provides a simple yet understandable explanation of certain abnormalities in the market that are make the markets inefficient and further support the thesis of this paper. Gitman in the appendix does present both sides of the equation a pro-EMH and a theory against-EMH. He also cites factors such as overreaction and excess volatility as evidence against the EMH. Overreaction is the direct result of investors reaction to news and the speed at which they process it; this may led to positive expectations that drive the prices of the stock higher or pessimistic predictions which then driving the price of the stock down-eventually the prices decline or gain depending on the scenario. Gitman defines excess volatility as "fluctuations in stock prices may be much greater than are warranted by fluctuations in their fundamental value" (Gitman); prices in the stock may deviate from changes in the fundamental-accounting (book value) value of a stock. After analyzing theoretical aspects of EMH it is pertinent to present applications of the theory and how in fact when put to work the theory in fact does not fulfill itself.
The Financial Times article discusses the change of the usage of the term fair value-a concept that stems out of the EMH. Previously the idea of fair value was the only tool used by many companies in order to value their assets from an accounting perspective. The International Accounting Standards Board was considering changing the same to "Exit", "Exchange" or current instead of using the term fair value. Fuller discusses that one of the victims of the financial crisis was the EMH; he states that "prices are irrelevant, but that they have lost their automatic primacy as a measurement tool" (Fuller). He cites two reasons why using the concept of fair value of the EMH in accounting statements proved to be erroneous. The first reason was that the fair value concept did not take into account illiquid markets and the second issue was that balance sheets of the institutions were not solid enough to manage the excess volatility of the markets. As Fuller wrote "the more difficult part was that the "fair valuing" of liabilities was never going to keep up, exposing a mismatch between stubbornly stable amounts owed on one side of the balance sheet, and volatile asset values on the other " (Fuller). Fuller believes that accounting standards should not take into account the fair value concept for the EMH for the reason that it would not provide a realistic picture of the actual financial situation of a company. He quotes Andrew Smither's book Wall Street Revalued in which he describes that fair value could be used "if markets were perfectly efficient" (qtd in Fuller). Finally Fuller states that money in the stock market is made by exploiting the inefficiencies although some still believe hold true to the EMH. The EMH "made it seem futile to read and think because it said that the market could not be beaten" (Fuller), however, people turned away from those ideas and consequently undermined the importance of the EMH.
In this article for the Wall Street Journal Jason Zweig discusses that even though markets are inefficient they are still nearly impossible to beat. He defines the EMH as we have done throughout this paper but he points out the uselessness of the EMH "the fact that the market price is the best available estimate doesn't mean that the market price is right" (Zweig). Zweig discusses the theories of a famed analyst Benjamin Graham who deprecatingly described the EMH as a theory that may have been important if it was in sync with reality. He then discusses the fact that some stocks during the financial crisis of 2009 lost more than half their value but then made a return close to 300%, as was the case of Bank of America or Alco which lost one third of its value and then gained 84%. Zweig quotes Graham again when talking about the two components of the price of a stock: the investment value and the speculative element. The investment value as Graham said "measures the worth of all the cash a company will generate now and in the future" (qtd in Zweig) and the speculative element consists of the "sentiment and emotion: hope and greed and thrill-seeking in bull markets, fear and regret and revulsion in bear markets" (qtd in Zweig). Zweig argues that predicting emotions of millions of people who participate in the market is impossible and in fact that is precisely what drives the prices of stock into rapid swings in both directions up and down. As Professor Meir Statman comments on the piece even though markets are inefficient "evidence does suggest that the market is not rational" (qtd. in Zweig) and therefore investors should not be guided by the belief that beating the market is easy. The article talks about how large institutional investors dumped over $25 billion worth of stocks during the period where stocks were priced significantly lower during the 2008-2009 crisis, but Zweig argues that overreaction may have guided those sales. Logic suggests that one should buy stocks when they are priced at their lowest point with hopes of gaining excess returns in a short to medium period of time.
The Wall Street Journal article was a good source because it further highlights the idea that EMH is not consistent with real world investor behavior. Yet at the same time it does not say that just because the markets are inefficient it is easy to make money, in fact it is probably harder to make money in an inefficient market because prices are changing constantly and future movements are impossible to quantify and manage. After presenting evidence of the dysfunctional nature of the EMH in the real world it is only but appropriate to present a theory which explains market inefficiencies.
Behavioral finance is emerging as an explanation as to why markets are inefficient. Behavioral finance is a field that studies the influence of investor psychology and its effect on the markets; it seeks to explain why markets are inefficient and the irrational behavior of investors. In other words, if EHM were true then in theory premiums or discounts of financial instruments should not exist. However, in reality this is not the case but the question really is why? In 1923 Selden in his book Psychology of the Stock Market proposed that the movements of prices in financial markets are influenced in a large part by the attitudes and behavior of the market participants. The emerging new paradigm of behavioral finance looks to serve as an alternative to the "behaviorally incomplete theory if finance now often referred to as standard or modern finance" (Olsen). It is important to note that although it seeks to replace modern financial theories and specially the EMH it does not completely reject the existing theories, it only limits the boundaries in which they function. Behavioral finance seeks to "understand and predict systematic financial market implications of psychological decision processes" (Olsen). In addition, behavioral finance is focused on the application of psychological and economic principles for the improvement of financial decision making (Olsen).
Ritter proposes in his research that behavioral finance is composed of two main elements: cognitive psychology and the limits of arbitrage (Ritter). Within cognitive psychology distinctive behaviors can be identified: heuristics-rules of thumb which make decision making easier, overconfidence-people are overly optimistic/confident of their skills, mental accounting-when people make two decisions instead of one when the situation demands a single course of action, framing-notion that how a concept is presented to an individual matters (Ritter), conservatism, and disposition effect.
The theory suggests that most financial decisions are influenced by certain predispositions that some investors may have which is a direct result of their experiences and are driven mostly by psychological factors as a result of this and as Shiller proposes "that the US markets are for the most part overvalued and points to various factors-among them psychological-that may explain the phenomena" (Shiller). As mentioned in previous paragraphs some of the anomalies in the markets are explainable through models which are based on behavior. The field proposes the definite alternative to the traditional EMH and in fact is changing the paradigms in finance.
Part IV
In this investigation, the aim was to assess the validity of the efficient market hypothesis in order to demonstrate that financial markets are inefficient. After examination of the research done in the field and returning to the original hypothesis presented at the beginning of this document, it is now possible to state with certainty that indeed markets are indeed inefficient. One of the most significant findings of this research was the detection of investor created market anomalies that consequently result in distortions of prices. It was also shown that the belief in the EMH is slowly but surely eroding among the financial community-to a greater extent among finance academics. The findings of the research suggest that prices in financial markets are moved not necessarily by economical factors but rather are they moved by emotions. The emotionality of investors has in many cases caused severe drops in the markets as evidenced by the dotcom bubble and the crash of 2008.
The EMH is not to be rejected completely, since some components of the theory are very valuable when conducting research and creating an idea of the role of information in financial markets. Yet when put into practice research shows that markets behave in complete opposition to the principles of the EMH and thus creating inefficiencies in the market that are either taken advantage of by savvy investors or causes losses to novices. Noise trading also affects the efficiency of the market since traders make decisions based on sporadic information and are typically following the herd. Trained investors tend to rely more on the fundamental analysis of assets. However, as one source cites market inefficiencies are not always profitable opportunities for traders considering that those differences in prices are short lived and by the action of the fundamental traders then prices are corrected thereby returning to levels close to the fair value.
The research was limited by the time constraint. In the six weeks which were provided the research time was limited and the topic could not be discussed in-depth. Therefore the information presented in this paper is limited to what was considered the most basic but yet fundamental for the reader in order to understand the main tenets of the EMH in layman's terms; however, by doing so the research had to exclude certain economic terms and theories that are relevant. Additionally, the research was also limited in length. The topic is too broad and there is a significant amount of information on the topic that putting all that down in 4,000 words results in many important research papers being omitted. Another limitation this research faced was there was a requirement for types of sources; it was difficult to find periodicals with relevant articles regarding EMH and market inefficiencies. Finally more research can be conducted to find further anomalies that are caused in the markets as a consequence of investor reaction to news or events which are not foreseen or accounted for when they initiated an investment.
