Empirical Challenges of the Efficient Market Hypothesis free essay sample

Following its initial proposition, the efficient market hypothesis has remained one of the most important topics of debate in the financial and economic literature. This paper provides a discussion of the empirical challenges of the hypothesis. 2. Efficient Market Hypothesis: Theory and Empirical Challenges There are three forms of the efficient market hypothesis: (i) the weak-form; (ii) the semi strong-from; and (iii) the strong-form (Fama, 1970, 1991). The weak-form suggests that asset prices already reflect all stock market information meaning that stock market information cannot be used to make abnormal returns on a risk-adjusted based. The semi strong-from suggests that in addition to stock market information, stock prices also reflect all publicly available information such as price-to-book ratios, dividend yield, price-to-cash flow and price-to-earnings ratios. The semi strong-form means that abnormal returns cannot be made by trading on stock market data and any other information that is disclosed to the general public about stocks (Reilly and Brown, 2009). We will write a custom essay sample on Empirical Challenges of the Efficient Market Hypothesis or any similar topic specifically for you Do Not WasteYour Time HIRE WRITER Only 13.90 / page Finally, the strong-form states that security prices reflect both public and private information (Reilly and Brown, 2009). The empirical evidence on the efficient market hypothesis is mixed. Some studies have showed that the efficient market hypothesis is valid while others have identified imperial challenges to the hypothesis. This paper will focus on the empirical challenges. One group of studies suggest that the idea that stock returns follow a random walk has no theoretical underpinning (e. g. , Niederhoffer and Osborne, 1966; Lo and MacKinlay, 1988; Poterba and Summers,1988). All these studies show that stock returns do not follow a random walk as suggested by the EMH. Other studies have shown that the hypothesis is only valid in developed stock markets. Accordingly emerging market stock returns can be predicted which raises serious concerns over the validity of the efficient market hypothesis in these markets (e. g. , D’Ambrosio, 1980; Harvey, 1993; Balaban, 1995; Grieb and Reyes, 1999; Kawakatsu and Morey, 1999). The idea that stock returns can be predicted in emerging market economies has enabled investors in developed stock markets to diversify the risk of their portfolios and enhance their returns by including emerging market assets as part of their portfolios (Harvey, 1993). Another body of research has observed the presence of stock market anomalies. For example Debondt and Thaler (1985) argue that stock markets tend to either overreact or underreact to information suggesting that the markets are not as efficient as the EMH suggests. In addition, Jegadeesh and Titman (1993) observe that stock prices tend to persist in a particular direction of movement suggesting the presence of momentum profits. These profits can be made by adopting a strategy that shorts stocks that performed poorly in the past and buying those that performed well in the past. Another commonly documented anomaly is the observation of premiums on low market-to-book value stocks, low price-to-earnings stocks; and low price-dividend stocks (e. g. , Banz, 1981; Reinganum, 1981). The documentation of premiums is also a challenge to the EMH because in an efficient market there should be no premium on a particular investment strategy. Following the documentation of the above stock market anomalies and the empirical evidence against the EMH a new finance theory known as behavioural finance theory has emerged with the objective of explaining the presence and persistence of stock market anomalies (Bodie et al. 2007). According to behavioural finance theory, investor behaviour is influenced by psychological factors, which means that stock market anomalies can be attributed to psychological-based theories. The investment decisions of individuals and the behaviour of stock prices are systematically influenced by the structure of market information as well as the charac teristics of investors (Bodie et al. , 2007). Behavioural finance theorists argue against the efficient market hypothesis on the grounds that the assumptions underlying the EMH are unrealistic. The traditional EMH framework assumes that investors are rational. However, Barberies and Thaler (2003) argue that this assumption is â€Å"too simple and very appealing†. While some investors may be rational in their thinking, it is difficult to conceptualise the behaviour of investors based solely on rationality. Some of the actions of investors are irrational and as such basing the EMH on a rational framework can lead to misleading conclusions about the efficiency of markets (Barberies et al. , 1998; Hong and Stern, 1999; Baberies and Thaler, 2003). Investors do not react to information in the manner in which the efficient market hypothesis suggests. Investors tend to initially overreact or underreact to information when it is first made available to the market (Barberies et al. , 1998; Hong and Stern, 1999). This means that the EMH is only a temporal phenomenon. During a market overreaction or underreaction, investors who have insight on what the right direction of movement should be can make abnormal returns on a risk adjusted basis by designing trading strategies consistent with the long-run reversal of the stock price to its true intrinsic value. Despite the overwhelming challenges highlighted above against the EMH, proponents of the EMH have argued that these anomalies cannot be attributed to failure on the part of market efficiency. Schwert (2004) contends that anomalies are wrongly attributed to failure of maret efficiency whereas other factors such as inadequacies in asset pricing models could be at work. The argument by Schwert (2004) is consistent with Fama and French (1993, 1996) who argue that the standard capital asset pricing model by Sharpe (1964); and Lintner (1965) cannot adequately explain the cross-section of stock returns. Fama and French (1993, 1996) showed that when a three-factor model is used, most of the anomalies disappear. With respect to overreaction and underreaction, Fama (1998) argues that the frequencies of overreactions and underreactions tend to be equal. The even split between overreaction and underreaction results in a zero overreaction. Consequently, the EMH cannot be rejected on the basis of overreaction and underreaction. Moreover, Fama (1998) contends that overreactions occur as a result of chance. Studies that document overreaction and underreaction have been accused of using bad models. Responding to behavioural theorists, Rubinstein (2001) argues that if investor irrationality affects stock prices, it will most likely be manifested through overconfidence which should make markets more efficient rather than inefficient. For example, it has been observed that mutual funds despite their active management tend not to outperform passive investment strategies (Jensen, 1968; Rubinestein, 2001). Schwert (2004) further observes that stock market anomalies tend to disappear or reverse after their discovery suggesting that anomalies reflect a temporal mispricing in stock markets. Once enough arbitrageurs have taken appropriate action against the mispricing, stock markets return to normal. 3. Conclusions and Recommendations Three different forms of the EMH have been suggested. The EMH has been a subject of debate and has been subject to a number of empirical challenges. Studies argue that the EMH does not hold because stock market anomalies continue to be documented. In addition, some argue that the EMH is only valid in developed stock markets and invalid in emerging markets. Furthermore behavioural theorists contend that the framework of the EMH is based on rational expectations whereas investors tend not to be rational in their thinking and behaviour. However, proponents of the hypothesis suggest that studies that reject the EMH are characterised by inherent weaknesses in their methodologies. For example, Fama (1998) attribute anomalies to the use of bad models to test the EMH. In addition, Fama and French (1993, 1996) argue that the cross-section of stock returns is a function of three factors (market factor, size factor and the book-to-market factor) and not a function of a single factor (market factor) as suggested in Sharpe (1964) and Lintner (1965). As can be observed, there is no point of agreement between the two groups of researchers. The opinion of this paper is that stock markets are efficient. The main issue is that researchers investigating the hypothesis tend to use models that may not be appropriate in testing the hypothesis.