Assignment on Efficient Market Hypothesis

Submitted By:

BBA 2018, Section C

Anupiya Kansakar (18740)

Khusbu Agrawal (18706)

Sanju Dangol (18723)

Sarita Pandey (18764)

Smarika Shakya (18789)

Sramina Tuladhar (187120)

Kathmandu University School of Management (KUSOM)

PichheTole, Gwarko, Lalitpur

Submitted To:

Mr. Niranjan Phuyal

Faculty of Investment and Portfolio Management

Date: 16 July, 2020

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Background

Efficient Market Hypothesis (EMH) is a hypothesis that states that share prices reflect all the
information. According to the hypothesis, stocks are traded at a fair value in exchanges which
makes it impossible for investors to purchase undervalued stocks and sell at inflated prices.
Lots of investors believe that by being able to identify the securities that are undervalued,
they will be able to earn profit when the value of those securities increases. For identifying
the value of securities, they use various valuation techniques for investment decisions. But
however EMH denies all of the techniques as invaluable and ineffective. Hence, it says that it
is almost impossible to outperform the market suggesting that profiting from predicting price
movements is difficult. The only way the price changes is due to new information. A market
is considered efficient if it reflects the new information by change in price instantly. As the
current price of securities reflect all the information, there is no high or low price for the
securities. The price of securities are adjusted based on the information before a trader is able
to trade in the market.

The EMH theory is also popularly known as the Random Walk Theory. The efficient market
theory was first proposed by the French Mathematician Louis Bachelier in 1900 in his thesis
“Theory of Speculation. “According to Bachelier, the past, present and even the speculated
future events are reflected in market price but show no apparent changes in the price. It has
been assumed that Bachelier actually took ideas from the Random Walk Model of Jules
Regnault.

In 1945, F.A Hayek stated that markets were the most efficient way of aggregating
information distributed among individuals and society. The traders are motivated to acquire
and act on private information to gain profit so they are the ones to contribute most to the
efficient market prices. Hence, in the competitive environment in the market, market prices
reflect all the available information and can move in response to new information. This is
because there is intense competition to profit from any new information. As more and more
investors make an effort to identify the undervalued or overvalued stocks, the chance of
taking advantage of such mispriced stocks would be lower. So relatively only few investors
are able to profit from the detection of mispriced securities.

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The Efficient Market theory become more popular in the 1960s when it has made possible to
compare calculations and prices of hundreds of stocks more quickly due to the use of
computers. In 1970, a paper by E.F. Fama was published on the evidence of the efficient
market hypothesis. It also extended and refined the existing theory and included definitions
for three forms of financial market efficiency namely weak, semi strong and strong.

Features of Efficient Market Hypothesis (EMH)

1. The prices of securities reflect all relevant information about the asset.
2. The EMH hypothesizes that stocks trade at their fair market value on exchanges.
3. It allows investors an opportunity to outperform; however, it is very difficult to do so.
4. With the disclosure of new information, the efficiency of the market increases,
diminishing the opportunities for excess returns.
5. Market efficiency does not suggest that the price of security is its true intrinsic value.
It only states that market participants cannot predict the future price of an asset on a
consistent basis.
6. EMH follows the random walk theory which proclaims that stocks take a random and
unpredictable path that makes all methods of predicting stock prices futile in the long
run.

3 Forms of EMH

The efficient market hypothesis can be classified into three parts. They are:
1. Weak Form
This form of market efficiency theory suggests that current market prices of securities
reflect their previous or historical prices. This implies that investors cannot predict
future price changes by inferring prices or patterns of prices from the past. It goes
further to say past performance is irrelevant to what the future holds for the stock.
Therefore future price changes can only be the result of new information becoming
available.

2. Semi- Strong Form

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 absorb new public information so that an investor cannot achieve positive risk-
adjusted returns on average by using fundamental analysis, which is based on public
information such as profitability, dividends, and various accounting ratios and
estimates.

3. Strong Form
Strong form EMH says that all information, both public and private, is priced into
stocks. Therefore, it assumes that no investor and insiders can gain advantage over the
market a whole since it implies perfect market, where the information are cost free
and available to everyone. So by definition, a market that is strong-form efficient is
also semi-strong and weak-form efficient.

Types of Stock Market

Fundamental and technical analyses are two different stock investment strategies used for
researching and forecasting the future growth trends of stocks.
1. Technical Analysis
Technical analysis refers to the analysis of security price by analyzing the past trends
and changes in price and volume of shares and by studying historical information of
business. It helps guide traders to what is most likely to happen given past
information by identifying patterns and charts that suggest what a stock will do in the
future. Here, the weak form EMH directly challenges the technical analysts whose
trades are based on the past price movements and chart trends.

2. Fundamental Analysis
Fundamental Analysis referrers to evaluating stocks by attempting to measure their
intrinsic values through using economic and accounting information to predict stock
prices. Here, semi-strong form EMH directly challenges the fundamental analysts
who believe in making a profit from the market by studying the fundamentals of a
stock.

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Evidences against

Many investors and researchers have disputed the Efficient Market Hypothesis in both
empirical and theoretical contexts.

Small-Firm Effect

It is a theory that supports the understanding that businesses that are either smaller in size or
function with a smaller amount of market capital are in a position to effectively compete with
and even outperform larger business enterprises. The small firm effect can also make a
difference in the potential returns to investors. It means that the companies who do not have
large capital assets and more established business, makes it easier to make quick decisions
and take advantage of what might be short-term events in the marketplace which eventually
increases the possibility of generating additional revenue.
Now, this theory challenges the strong form of the efficient market hypothesis. Small
company bias has been a reoccurring theme over history when trends should not be
predictable. The small firm effect cannot be completely explained by EMH and thus remains
an anomaly to the EMH.

Excess Volatility

The critics of EMH believe that stock market appears to exhibit excessive volatility. It
suggests that the fluctuations in stock prices may be much greater than is warrened by their
fundamental values. Though some analysts believe that the stability has nothing to do with
market efficiency and it is wrong to criticize Efficient Market Hypothesis based on this
ground. However, it is also important to note that prices move too much to be rational
forecasts of future earnings discounted at a constant rate. Trading of fundamental and
momentum investors lead to alternations in prices, thus, an excess of volatility. This excess of
volatility cannot be explained by the EMH. Hence, excess volatility is equivalent to
predictability in stock prices, which is a direct violation of the EMH.

Insider Training
Insiders who are in a better position in the company and who are better informed about
overall company developments, such as department managers, board chairman, etc., are more
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successful in anticipating future stock price changes, compared to small shareholders and
company employees. Likewise, with the help of privileged information, insiders successfully
anticipate changes in stock prices and achieve high return. Moreover, critics have suggested
that financial institutions and corporations have been able to decrease the efficiency of
financial markets by creating private information

January Effect

The January Effect refers to a seasonal propensity for stock prices to rise in January. It's
ascribed to an uptick in buying activity following a dip in December, when investors use tax
loss harvesting to balance capital gains. January effect seems to be diminishing in large
companies in recent years but evidences are still seen for small companies. Economists argue
that this effect is due to tax issues as during December the investors sell their stocks as to
decrease their tax liabilities and again during the month of January they repurchase the stocks
driving up the stock prices. Even though it may be a good argument it does not explain why
institutions which are not liable to pay income taxes such as private pension funds do not take
advantage of this situation. Similarly, we can also say that investors wait years before
realizing any kind of losses. For example: As a human being one does not simply sell their
stocks on loss, as everyone as a urge to sell in profit, and observe the market seasonality as
whole before selling their stocks.

Short-run Effect and Long-Run Return Reversals

When stock returns are measured in the short run, several studies demonstrate that there are
some positive serial correlations. Many other investigations, on the other hand, have shown
evidence of negative serial correlation. Mean reversion is another phrase for return reversal.
This suggests that equities that have performed poorly in the past are now performing well.
This indicates that stocks that have performed poorly in the past are more likely to perform
well in the future since future price changes will be predictable, implying that stock prices are
not a random walk.

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Major Takeaways from the article “Efficient Market Hypothesis and Myths”

In this article, the main focus was given to the efficient market hypothesis where we learned
about how it works in the stock market and we also learned about how it states that the share
prices reflects all the information. From the article, we also go to know that profiting from
predicting price movements are very difficult and the market is said to be efficient when the
prices are adjusted quickly with the new information.
As there is increase in the competition among the investors to profit from the new
information, the existence of the efficient market is established. Efficient market helps the
investors to identify the over-priced and under-priced stocks so that they can buy the stocks
for less and sell others in high price. The main implication of the EMH is that at any point the
prices of securities and stocks in efficient markets reflect all known information available to
the investors which helps the investors to make an accurate decision to buy or sell the
securities.
From the article, we found out that the theory of efficient market hypothesis says that the
market is rational and that the investors aren’t able to beat the market as it is already priced
perfectly. It is said that security prices reflected all available information and the markets
weren’t subject to bubbles or panics and the stocks are always traded at their current fair
market value.

Major Takeaways from the article “Does the Stock Market Overreact?”

In the article, it is mentioned that most people tend to overreact when there is an unexpected
new events occurring from which the stock prices may change. There is also mentioned the
term appropriate reaction which is also known as a well-established norm that means it gives
correct reaction to new information. From the article, we also got to know that the
overreaction in the market is caused by the day to day fluctuations in the profits of existing
investments which tend to have an excessive and absurd influence on the market.
From the overall article, we found out that the predictions of the overreaction hypothesis have
a positive effect in the portfolios as portfolios of prior losers are found to outperform prior
winners. Even though the latter are significantly more risky, after the formation of portfolio
there will be seen that the losing stocks will earn more than the winning stocks.

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Conclusion

The Efficient Market Hypothesis (EMH) states that share prices reflect all available
information and therefore consistent alpha formation is impossible. Stocks on exchanges
always trade at their fair worth, making it impossible for investors to buy undervalued stocks
or sell for inflated prices. The features of EMH are prices of securities reflect all relevant
information about the asset, it allows investors an opportunity to outperform and with new
information, the efficiency of the market increases, diminishing the opportunities for excess
returns. Similarly, the efficient market hypothesis can be classified into weak form, semi-
strong form and strong form. The evidence against the Efficient Market Hypothesis is given
in both empirical and theoretical contexts. They are: Small-Firm Effect, Excess Volatility,
January Effect and Short-run Effect and Long-Run Return Reversals.
Regardless of the fact that no theory is perfect, the efficient market hypothesis is
characterized by a majority number of empirical evidence. The vast majority of market
students agree that markets are incredibly effective. Some recent research suggests that there
is under and over reaction in security markets, according to opponents of the efficient
markets theory. However, it's worth noting that these studies are divisive and, in general,
haven't stood the test of time.
As in summary, the efficient markets theory remains the most accurate account of price
changes in financial markets. The EMH is a vital feature that should be revisited from time to
time, especially now that computerization has made markets more automated, quicker, and
efficient. While perfect efficiency is unlikely to be attained in the near future, it is expected to
improve with time.