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Is the efficient market hypothesis valid (EMH)?
I want to discuss the various merits of the EMH, this is something that basically says that the stock market is impossible to predict and hence it is impossible to make super-normal profits by anything other than sheer luck. I have always watched the stock market with an interest as an easy way to earn extra money, but was wondering the experiences of other on this subject. For those who are unfamiliar with the principle of EMH I have attempted to explain it below (actually this is an excerpt from a report I wrote at university):
"‘In the efficient market undervalued or overvalued shares do not exist, and therefore it is not possible to develop trading rules which will beat the market by, say, buying identifiable under priced shares. If a share is traded on the stock market which is priced efficient this means that all investors know what a share is really worth….’
When people purchase on the stock market they do it with the aim of generating a return on what they originally invested, these people are known as investors and in their efforts they try to make profit and to that end they try to beat the market, in order to make superior profits. Efficient market hypothesis (EMH) was created by Eugene Fama in 1970, and this hypothesis suggests that at any given time prices fully reflect all available information on a particular share or the market in general. If this EMH were true then no investor would have an advantage in predicting the return on shares as no investor would be privy to any more information than anyone else and so would have no better chance at generating a return than anyone else.
There remains an element of unpredictability, information that can influence stock prices is not strictly limited to financial news or research, information about legal, social, political, technological and environmental events coupled with the perceptions of these events by investors will be reflected in stock prices.
Since prices of stock only change due to the information available to the market and everyone has access to the same information the possibility of investors earning abnormal profits is negated. In an efficient market prices become totally unpredictable (random), this is because prices only change with news (new information) and news by it’s very nature is unpredictable. Thus, it follows that and investment pattern cannot be recognised, and so a planned approach to investment, therefore, cannot be successful.
The ‘random walk’ of prices, that is, the past changes in prices cannot be used to predict the future changes, is well known through-out the finance world and particularly applies in EMH. The result is that all investment strategies aimed at beating the market are doomed to failure.
In reality obvious arguments can be put forward against EMH. The most obvious of which would be to point out that there are investors who have beaten the market, consistently. As Warren Buffett (a very successful investor) so eloquently put it “I’d be a bum in the street with a tin cup if the market were efficient.”. This clearly is a major argument against EMH and Warren Buffet is living proof of it. Though it can be pointed out that there are investment houses and portfolio managers with more successful pasts than others, which begs the question: how can stock performance be random (in following with EMH) when there are investors profiting from the market and earning superior returns.
Contrary to EMH there are consistent patterns present in the market. The most obvious and much written-about ‘January effect’ and ‘weekend effect’ are two examples of such patterns. In January it is tradition that higher returns tend to be earned, and prices tend to be higher over the weekend.
A look in the effects of investor psychology on stock prices, known as behavioural finance, reveals that there are predictable patterns to be found on the stock market. As it currently operates investors buy undervalued shares and sell overvalued shares, the result of which is short of efficient.
It has been suggested by Paul Krugman that short-term shareholder investors buy and sell the latest and most trendy stocks. The result of which is a distortion in market prices and thus an inefficient market. This demonstrates that prices are actually being altered by the investors’ own actions.
The theory of EMH counters this because it does not actually dismiss the possibility of anomalies that can lead to the generation of abnormal profits. EMH doesn’t even require the prices to be a fair reflection of their value all of the time, they can be over/under valued only randomly and they will eventually realign themselves with their normal value. This would still mean that investment strategies cannot be formulated since random fluctuations cannot be predicted, because if randomness was predictable (except by luck) then it wouldn’t be random.
This is accounted for in the hypothesis which notes that an over performing investor does so out of luck not skill. This is simply due to probability, in a market place of several million there are always going to be those who under perform, those who over perform and those who are average. Warren Buffett's success could be explained by, for example, giving a dice each to several million investors and asking them each to roll a six in fifty consecutive times. Most will fail but there might be one or two who manage it.
For a market to become efficient then investors must perceive the market to be inefficient (so that they keep investing), the strategies based on an inefficient market are what would keep an efficient market going. Also information has to be easily accessible and cheap enough to acquire and should be available to all at the same time. Transaction costs are also required to be less than expected returns of a strategy. But above all an investor must believe they can out perform market expectations.
These requirements for an efficient market are difficult to reconcile with the real world and so there are a number of ‘watered-down’ version of EMH which may be more realistically applied, these can be called the degrees of efficiency and are as follows:
1. Strong efficiency – This is EMH in its purest form, and stipulates that all public and private knowledge is reflected in share pricing. Even insider information could not give an investor an edge.
2. Semi-strong efficiency -This form of EMH implies that all public information is calculated into a stock's current share price. Fundamental or technical analysis cannot be used to achieve superior gains. Insider information could be useful.
3. Weak efficiency – This is EMH in it’s weakest form and only claims that all past prices of a stock are reflected in today's stock price. Technical analysis cannot be used to predict and beat a market."
Naturally this is copyrighted to me (Gabriel Dragffy), and I hope it was enlightening. Of course if anyone has any insider information on some companies I'd love to hear it!
"‘In the efficient market undervalued or overvalued shares do not exist, and therefore it is not possible to develop trading rules which will beat the market by, say, buying identifiable under priced shares. If a share is traded on the stock market which is priced efficient this means that all investors know what a share is really worth….’
When people purchase on the stock market they do it with the aim of generating a return on what they originally invested, these people are known as investors and in their efforts they try to make profit and to that end they try to beat the market, in order to make superior profits. Efficient market hypothesis (EMH) was created by Eugene Fama in 1970, and this hypothesis suggests that at any given time prices fully reflect all available information on a particular share or the market in general. If this EMH were true then no investor would have an advantage in predicting the return on shares as no investor would be privy to any more information than anyone else and so would have no better chance at generating a return than anyone else.
There remains an element of unpredictability, information that can influence stock prices is not strictly limited to financial news or research, information about legal, social, political, technological and environmental events coupled with the perceptions of these events by investors will be reflected in stock prices.
Since prices of stock only change due to the information available to the market and everyone has access to the same information the possibility of investors earning abnormal profits is negated. In an efficient market prices become totally unpredictable (random), this is because prices only change with news (new information) and news by it’s very nature is unpredictable. Thus, it follows that and investment pattern cannot be recognised, and so a planned approach to investment, therefore, cannot be successful.
The ‘random walk’ of prices, that is, the past changes in prices cannot be used to predict the future changes, is well known through-out the finance world and particularly applies in EMH. The result is that all investment strategies aimed at beating the market are doomed to failure.
In reality obvious arguments can be put forward against EMH. The most obvious of which would be to point out that there are investors who have beaten the market, consistently. As Warren Buffett (a very successful investor) so eloquently put it “I’d be a bum in the street with a tin cup if the market were efficient.”. This clearly is a major argument against EMH and Warren Buffet is living proof of it. Though it can be pointed out that there are investment houses and portfolio managers with more successful pasts than others, which begs the question: how can stock performance be random (in following with EMH) when there are investors profiting from the market and earning superior returns.
Contrary to EMH there are consistent patterns present in the market. The most obvious and much written-about ‘January effect’ and ‘weekend effect’ are two examples of such patterns. In January it is tradition that higher returns tend to be earned, and prices tend to be higher over the weekend.
A look in the effects of investor psychology on stock prices, known as behavioural finance, reveals that there are predictable patterns to be found on the stock market. As it currently operates investors buy undervalued shares and sell overvalued shares, the result of which is short of efficient.
It has been suggested by Paul Krugman that short-term shareholder investors buy and sell the latest and most trendy stocks. The result of which is a distortion in market prices and thus an inefficient market. This demonstrates that prices are actually being altered by the investors’ own actions.
The theory of EMH counters this because it does not actually dismiss the possibility of anomalies that can lead to the generation of abnormal profits. EMH doesn’t even require the prices to be a fair reflection of their value all of the time, they can be over/under valued only randomly and they will eventually realign themselves with their normal value. This would still mean that investment strategies cannot be formulated since random fluctuations cannot be predicted, because if randomness was predictable (except by luck) then it wouldn’t be random.
This is accounted for in the hypothesis which notes that an over performing investor does so out of luck not skill. This is simply due to probability, in a market place of several million there are always going to be those who under perform, those who over perform and those who are average. Warren Buffett's success could be explained by, for example, giving a dice each to several million investors and asking them each to roll a six in fifty consecutive times. Most will fail but there might be one or two who manage it.
For a market to become efficient then investors must perceive the market to be inefficient (so that they keep investing), the strategies based on an inefficient market are what would keep an efficient market going. Also information has to be easily accessible and cheap enough to acquire and should be available to all at the same time. Transaction costs are also required to be less than expected returns of a strategy. But above all an investor must believe they can out perform market expectations.
These requirements for an efficient market are difficult to reconcile with the real world and so there are a number of ‘watered-down’ version of EMH which may be more realistically applied, these can be called the degrees of efficiency and are as follows:
1. Strong efficiency – This is EMH in its purest form, and stipulates that all public and private knowledge is reflected in share pricing. Even insider information could not give an investor an edge.
2. Semi-strong efficiency -This form of EMH implies that all public information is calculated into a stock's current share price. Fundamental or technical analysis cannot be used to achieve superior gains. Insider information could be useful.
3. Weak efficiency – This is EMH in it’s weakest form and only claims that all past prices of a stock are reflected in today's stock price. Technical analysis cannot be used to predict and beat a market."
Naturally this is copyrighted to me (Gabriel Dragffy), and I hope it was enlightening. Of course if anyone has any insider information on some companies I'd love to hear it!
| sniffass wrote: |
| I want to discuss the various merits of the EMH, this is something that basically says that the stock market is impossible to predict and hence it is impossible to make super-normal profits by anything other than sheer luck. I have always watched the stock market with an interest as an easy way to earn extra money, but was wondering the experiences of other on this subject. For those who are unfamiliar with the principle of EMH I have attempted to explain it below (actually this is an excerpt from a report I wrote at university):
"‘In the efficient market undervalued or overvalued shares do not exist, and therefore it is not possible to develop trading rules which will beat the market by, say, buying identifiable under priced shares. If a share is traded on the stock market which is priced efficient this means that all investors know what a share is really worth….’ When people purchase on the stock market they do it with the aim of generating a return on what they originally invested, these people are known as investors and in their efforts they try to make profit and to that end they try to beat the market, in order to make superior profits. Efficient market hypothesis (EMH) was created by Eugene Fama in 1970, and this hypothesis suggests that at any given time prices fully reflect all available information on a particular share or the market in general. If this EMH were true then no investor would have an advantage in predicting the return on shares as no investor would be privy to any more information than anyone else and so would have no better chance at generating a return than anyone else. There remains an element of unpredictability, information that can influence stock prices is not strictly limited to financial news or research, information about legal, social, political, technological and environmental events coupled with the perceptions of these events by investors will be reflected in stock prices. Since prices of stock only change due to the information available to the market and everyone has access to the same information the possibility of investors earning abnormal profits is negated. In an efficient market prices become totally unpredictable (random), this is because prices only change with news (new information) and news by it’s very nature is unpredictable. Thus, it follows that and investment pattern cannot be recognised, and so a planned approach to investment, therefore, cannot be successful. The ‘random walk’ of prices, that is, the past changes in prices cannot be used to predict the future changes, is well known through-out the finance world and particularly applies in EMH. The result is that all investment strategies aimed at beating the market are doomed to failure. In reality obvious arguments can be put forward against EMH. The most obvious of which would be to point out that there are investors who have beaten the market, consistently. As Warren Buffett (a very successful investor) so eloquently put it “I’d be a bum in the street with a tin cup if the market were efficient.”. This clearly is a major argument against EMH and Warren Buffet is living proof of it. Though it can be pointed out that there are investment houses and portfolio managers with more successful pasts than others, which begs the question: how can stock performance be random (in following with EMH) when there are investors profiting from the market and earning superior returns. Contrary to EMH there are consistent patterns present in the market. The most obvious and much written-about ‘January effect’ and ‘weekend effect’ are two examples of such patterns. In January it is tradition that higher returns tend to be earned, and prices tend to be higher over the weekend. A look in the effects of investor psychology on stock prices, known as behavioural finance, reveals that there are predictable patterns to be found on the stock market. As it currently operates investors buy undervalued shares and sell overvalued shares, the result of which is short of efficient. It has been suggested by Paul Krugman that short-term shareholder investors buy and sell the latest and most trendy stocks. The result of which is a distortion in market prices and thus an inefficient market. This demonstrates that prices are actually being altered by the investors’ own actions. The theory of EMH counters this because it does not actually dismiss the possibility of anomalies that can lead to the generation of abnormal profits. EMH doesn’t even require the prices to be a fair reflection of their value all of the time, they can be over/under valued only randomly and they will eventually realign themselves with their normal value. This would still mean that investment strategies cannot be formulated since random fluctuations cannot be predicted, because if randomness was predictable (except by luck) then it wouldn’t be random. This is accounted for in the hypothesis which notes that an over performing investor does so out of luck not skill. This is simply due to probability, in a market place of several million there are always going to be those who under perform, those who over perform and those who are average. Warren Buffett's success could be explained by, for example, giving a dice each to several million investors and asking them each to roll a six in fifty consecutive times. Most will fail but there might be one or two who manage it. For a market to become efficient then investors must perceive the market to be inefficient (so that they keep investing), the strategies based on an inefficient market are what would keep an efficient market going. Also information has to be easily accessible and cheap enough to acquire and should be available to all at the same time. Transaction costs are also required to be less than expected returns of a strategy. But above all an investor must believe they can out perform market expectations. These requirements for an efficient market are difficult to reconcile with the real world and so there are a number of ‘watered-down’ version of EMH which may be more realistically applied, these can be called the degrees of efficiency and are as follows: 1. Strong efficiency – This is EMH in its purest form, and stipulates that all public and private knowledge is reflected in share pricing. Even insider information could not give an investor an edge. 2. Semi-strong efficiency -This form of EMH implies that all public information is calculated into a stock's current share price. Fundamental or technical analysis cannot be used to achieve superior gains. Insider information could be useful. 3. Weak efficiency – This is EMH in it’s weakest form and only claims that all past prices of a stock are reflected in today's stock price. Technical analysis cannot be used to predict and beat a market." Naturally this is copyrighted to me (Gabriel Dragffy), and I hope it was enlightening. Of course if anyone has any insider information on some companies I'd love to hear it! |
How dare you make such an accusation of plagerism, at least substantiate that patent remark. I resent that reply in the extreme and would like to point out that I copied it from a report that I WROTE when I was at university, the report was the result of careful and time-consuming research. Why is that so hard to believe?? Maybe you never went to uni and never had to create your own work before.
This post was written with a genuine curiosity in to how others may have experienced the real-world stock market. As I said, I have always speculated but since only recently I finished up my studies I don't have the money to gamble.
I mentioned that I originally wrote this in the initial post and if you can't read that then you should probably get yourself to a school or a university.
So when you have discovered how to read you can see what you think of this message.
Regards,
Gabe
This post was written with a genuine curiosity in to how others may have experienced the real-world stock market. As I said, I have always speculated but since only recently I finished up my studies I don't have the money to gamble.
I mentioned that I originally wrote this in the initial post and if you can't read that then you should probably get yourself to a school or a university.
So when you have discovered how to read you can see what you think of this message.
Regards,
Gabe
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