Market efficiency: Theory, tests and applications

Abstract

Many finance theories and asset pricing theories are written under the assumption that markets are efficient. Consequently, the topic has attracted substantial scholarly interest. There are three types of market efficiency depending on what type of information is reflected in security prices. Many academic studies have unearthed numerous anomalies in the US capital markets that seem to contradict market efficiency. Many of these anomalies seem to exist in other parts of the world as well. This chapter provides an overview of some of the anomalies and throws light on what, if at all, investors can do to exploit these anomalies. There is no other proposition in economics that has more solid empirical evidence supporting it than the Efficient Market Hypothesis ⋯. In the literature of finance, accounting, and the economics of uncertainty, the EMH is accepted as a fact of life. Prof Michael C Jensen in "Some Anomalous Evidence Regarding Market Efficiency," Journal of Financial Economics 1978 Prediction is very difficult, especially if it's about the future. Nils Bohr, Nobel laureate in Physics This message (that attempting to beat the market is futile) can never be sold on Wall Street because it is in effect telling stock analysts to drop dead. Prof Paul Samuelson, Nobel laureate in Economics I have personally tried to invest money, my client's money and my own, in every single anomaly and predictive device that academics have dreamed up ⋯. I have attempted to exploit the so called year-end anomalies and a whole variety of strategies supposedly documented by academic research. And I have yet to make a nickel on any these supposed market inefficiencies ⋯ a true market inefficiency ought to be an exploitable opportunity. If there's nothing investors can exploit in a systematic way, time in and time out, then it is very hard to say that information is not being properly incorporated into stock prices. Prof Richard Roll, UCLA And Portfolio Manager It's just not true that you can't beat the market. Every year about one-third of the fund managers do it. Of course, each year it is a different group. Stovall, Robert, Investment Manager, ABC 20/20 Interview "Who Needs the Experts," 1992 Efficient Market Hypothesis states that all relevant information is fully and immediately reflected in a security's market price, thereby assuming that an investor will obtain an equilibrium rate of return. In other words, an investor should not expect to earn an abnormal return (above the market return) through either technical analysis (usage of past stock price patterns to predict future) or fundamental analysis. It implies that if new information is revealed about a firm it will be incorporated into the share price rapidly and rationally, with respect to the direction of the share price movement and the size of that movement. In an efficient market no trader will be presented with an opportunity for making a return on a share (or other security) that is greater than a fair return for the risk associated with that share (or any other security). The absence of abnormal profit possibilities arises because current and past information is immediately reflected in current prices. It is only new information, which causes prices to change. In the major stock markets of the world, prices are set by forces of supply and demand. There are hundreds of analysts and thousands of traders receiving new information on a company through electronic and paper media. The moment an unexpected, positive piece of information leaks out, investors will act and prices will rise rapidly to a level that gives no opportunity to make further profit. © 2009 Springer-Verlag Berlin Heidelberg.