Efficient Markets Hypothesis
The aim of accounting information is to present the financial figures about the performance of particular company so as to assist shareholders, investors, managers and authorities in government in decision making. Financial information is also important in the evaluation of usefulness of data to investors, shareholders and other interested users. Moreover, the importance of capital market investigation and research is to find out the relationship between returns on security and accounting numbers or information and to assess whether or not there is carriage of information content from accounting data to security market . If there is carriage of information, then it is important that it is impounded to the security price.
The essence of financial reporting is to offer creditors and investors with important information that assist them analyze and assess the amount, uncertainty and timing of cash flows to facilitate them in making national investment band credit decisions. Over the past years, accounting research and study has come up to analyze the importance of accounting data to shareholders and investors among other interest groups by substantiating the relation between the security prices and the release of the accounting numbers and information. The significance of the study and other studies which have been done earlier is to justify the efficiency of capital markets.
Whenever there is a capital market which is efficient, security returns (prices) respond instantaneously in an unbiased manner to impound in a manner that there is no opportunity left to participants in the market to earn an abnormal return which is consistent. Empirical research which has been done before in finance and accounting brings forth evidence which is in support of hypothesis in market efficiency. These studies show the accounting numbers and information are of value to decisions being made by investors as they are related to security returns. According to some studies which have been done recently there is contradicting information in anomalies in stock markets and efficiency market hypothesis (EMH).
This paper is designed in such a way that we shall review the some aspects of market efficiency in capital markets and its implication. In the paper we shall discuss the various forms of market efficiency. Furthermore, the paper is aimed at discussing the effects of information to security prices.
Efficient Market Hypothesis
Efficient market hypothesis is also known as Random Walk Theory, this theory normally indicate that stock prices show a full reflection of available information about the worth of the company or organization, and this information cannot be used to earn excess profits which is overall in the market. This theory deals with the reasons why there are changes in stock prices I the security markets and how the changes are effected. Efficient market hypothesis has an adverse impact on investors as well as it has on managers.
In security markets, many investors normally indentify undervalued securities which are expected to increase in prices in the near future and particularly those securities that will increase more than the others . All investors, investment managers included, usually believe that they are able to select securities which will beat the rest in the market, eventually gaining huge profits. In order to accomplish this goal, investors normally use various techniques in forecasting and valuation so as to assist them in making investment decisions. Therefore, a substantial profit can be defined as the edge possessed by any investor.
This theory of market efficiency has generated discussions which are passionate compared to other theories related to financial matters. An economist in financial matters Schwert (2001) noted that, “there is no other proposition in economics which has more solid empirical evidence supporting it than the Efficient Market Hypothesis”.
The theory of EMH indicates that investors find it very difficult to make profits through predicting price movements. The arrival of new information in the market is the basic catalyst of price changes. The efficiency of a market is determined when prices of securities adjust quickly without being biased on the arrival of the new information. Hence, the immediate prices of securities replicate the available information in the market at any point in time. Therefore, one should not come up with a conclusion that stock prices are overrated or underrated. Normally, the adjustment of prices usually occurs before an investor can trade on or benefit from a new set of information that is released to the market.
It is believed that I order to have an efficient market investors must compete among themselves from any new piece of information that is availed. It is valuable for investors to indentify over valued and under valued stocks in terms of prices, this valuation allows investors to purchase stocks for more less than their actual value and sell others higher than they are really worth. As a result many people end up spending more time and resources in order to detect stocks which have been mispriced. According to, Shleifer (2000), he says that,
“Naturally, as more and more analysts compete against each other in their effort to take advantage of over- and under-valued securities, the likelihood of being able to find and exploit such mispriced securities becomes smaller and smaller. In equilibrium, only a relatively small number of analysts will be able to profit from the detection of mispriced securities, mostly by chance. For the vast majority of investors the information analysis payoff would likely not outweigh the transaction costs,” pg 78.
In order to see the success of EMH one can put this theory in a slogan form: Trust market prices! In this aspect, the prices of securities in an efficient market replicate the information that is known and available to the investors at any point in time. This signifies that investors cannot be fooled in any way and they end up purchasing securities at a fair prices; this means that what investors pay for is exactly what they get. Getting a fair price in securities does not mean that the securities will perform at the same rate nor even is there a likelihood of the prices fluctuating in the same way for all the securities . As explained in the theory of capital markets, the anticipated profit from a stock is mainly a function of its threat. The worth of the stock replicates the current worth of its anticipated potential cash flows, which integrates various aspects for example risk of bankruptcy, volatility, and liquidity. On the other hand, since prices are rationally placed, the changes in that matter are expected to be unpredictable and random; this is because new information is not predictable.
Criticism of the Hypothesis
The efficient market hypothesis is in support of randomness in prices of the securities and in this hypothesis factors such as short-run relationship between changes in stock prices have been looked into. Generally, this hypothesis indicates and supports that there are no memories in the stock market: this signifies that, the way some prices in stock behaved in the past cannot define how they will behave in future. Recent research have shown that short-run successive relationships are not zero and that the continuation of too many serial moves which are in the same direction enable the researchers to disregard the EMH hypothesis that there is a random walk in stock prices. In addition, in their research Lo, Mamaysky & Wang (2000) they find that, through the application of sophisticated and complex nonparametric statistical methods that normally recognize flows and patterns, some signals in the stock prices used technical analysts to gain some predictive powers which were modest.
In the field of behavioral finance psychologists and economists find such short-run impetus not to be consistent with feedbacks of psychological mechanisms. Individuals and investors perceive a rise in stock prices and are lured into market in an effect which can be termed as to a band wagon . For instance the rise of prices in the financial market of the United States, during mid 1990s was described by some economists as a result of psychological reaction which lead to irrational enthusiasm.
Although the under reaction to new information and hypotheses on behavioral change about the effects of the band wagon may sound reasonable enough, there is rather thin evidence that that such effects occur in a systematic manner in the stock market. In some studies which have been done recently, researchers have surveyed considerable sum of empirical work about event studies that seeks to find out whether security prices respond to new information efficiently. The study events which have been mentioned include stock splits, earnings surprises, new exchange listings, dividend actins, initial public offerings, and mergers. In his research Fama finds out that noticeable information under-reaction by investors is significantly as popular as overreaction to information, and post-event persistence of returns which are abnormal is regular as post-event reversals. Rasches (2001), in his study shows that,
“Many of the return “anomalies” arise only in the context of some very particular model, and that the results tend to disappear when exposed to different models for expected “normal” returns, different methods to adjust for risk, and when different statistical approaches are used to measure them. For example, a study, which gives equal-weight to post-announcement returns of many stocks, can produce different results from a study that weight the stocks according to their value. Certainly, whatever momentum displayed by stock prices does not appear to offer investors a dependable way to earn abnormal returns”, pg 56.
After the publication in the financial literature, many patterns which are predictable tend to disappear. In this scenario there are always two explanations for such a departure in patterns. The first explanation that can go well with this scenario is that there is sifting of data by researchers. Normally there is a tendency to focus more on the results that are of challenge to the perceived knowledge, and every time, there will be a blend of a certain technique and a particular sample that will produce important statistical results which challenge the theory of efficient markets . On the other hand, practitioners and economists are able to learn quickly about patterns which are predictable and they make use of it to a point that it is no longer money-making and profitable. It is my view that such patterns were not large and stable enough to promise consistent investment superiority results and more importantly such collusions and results will not be of significance to investors after the publicity they have received.
The only problem that is associated with predictable patterns or anomalies is that investors cannot depend on them since they are not dependable from time to time. In addition, these effects of non-randomness are minimal relative to the costs of transaction when one tries to make use of them. They may not offer a niche for investors to try and make excessive risk adjusted profits.
Many researchers and investors have had disputes in arguments on the efficient market hypothesis both in theory and in practice. Some economists attribute the inefficiency in stock and financial markets to a group of multiple cognitive biases for example overreaction, overconfidence, information bias, representative bias and other errors which are in connection to human beings due to information processing and reasoning. These reasoning and information interpretation errors lead investors in buying growth stocks and avoiding value stocks which are essential. These errors give investors who reason a chance to profit from neglected stocks and other stocks which have been overrated. There has been mixed empirical evidence but in general this evidence has not supported the strong structures of efficient market hypothesis. Research has shown that stocks with low P/E values are normally associated to greater returns.
Obvious anomalies occur in financial markets, one such example of an anomaly is the speculative economic bubbles. In such a case the market is normally driven by investors who particularly operate on irrational enthusiasm, these types of buyers take little or no notice of value in stocks. When such bubbles occur in the market what follows is an overreaction of sellers whereby they end up in frantic selling or disposing of stocks which permits astute investors to purchase stocks at a price which is bargained. Investors who are rational do not benefit much from shortened irrational bubbles since markets can remain solvent for a longer time than it is estimated . The recent global financial crisis was blamed on the EMH, since it was argued that financial leaders believed too much in hypothesis hence leading to chronic underestimation of the dangers involved in breaking asset bubbles. The hypothesis has been deemed as a useless tool of examining how markets function in reality.
In conclusion, if the decisional making process of the efficient market hypothesis as one which is guide by knowledge of aspects governing decision making, it is then conclusively seen that efficient market hypothesis is flawed and inconsistent. The hypothesis fails to come up with a proper and appropriate format and framework for expectations regarding information. Under EMH one cannot argue that the decisions of an investor are irrational given that the factors in the hypothesis are uncertain. In order for an investor to make rational decisions he/she would need information about future income flows and a proper discount factor, which in this case the investor has no knowledge of the same. Finally as indicated earlier in the paper the investor is faced by uncertainty not by risk as is expressed in the efficient market hypothesis.
Dechow, P.M., et al. (2001) Short-sellers, fundamental analysis, and stock returns, Journal of Financial Economics 61, 77-106.
Lesmond, D., Schill, M., & Chunsheng Z. (2001). The Illusory Nature of Momentum Profits, unpublished manuscript: Tulane University.
Lo, A. W., Mamaysky, H., & Wang, J. (2000). Foundations of Technical Analysis: Computational Algorithms, Statistical Inference, and Empirical Implementation, Journal of Finance, 55, 1705-1765.
Rasches, M. (2001). Massively Confused Investors Making Conspicuously Ignorant Choices (MCI-MCIC): Journal of Finance, 56:5, 1911-1927.
Schwert, G. W. (2001). Anomalies and Market Efficiency, in G. Constantinides, et. al.: Handbook of the Economics of Finance, North Holland.
Shleifer, A. (2000). Inefficient Markets: An Introduction to Behavioral Finance, New York: Oxford University Press.