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The Efficient Market Hypothesis

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Essay title: The Efficient Market Hypothesis

The Efficient Market Hypothesis

The term Efficient Market Hypothesis implies that that current stock prices fully reflect all available information about a firm, that any new information revealed about a firm will be incorporated into its share price rapidly and that the subsequent rise or fall in share price will be to the correct amount in relation to the new information that has come to light. It was Eugene Fama who first used the term EMH in the 1960’s and the subject has been the centre of many disagreements between those who support the theory and those oppose it ever since.

The Efficient Market Hypothesis states that any return on a share that is greater than the fair return for the riskiness associated with that share occurs only by chance. EMH does not imply that higher than average returns cannot be made on shares, on the contrary, it suggests that around 50% of shares or securities will produce higher than average returns while around 50% will produce lower than average returns. What EMH does imply is that profiting from predicting price movements is a very difficult and unlikely task, in an efficient market no trader should be able to make greater than average returns on shares through any means other than pure luck. EMH recognises the fact that at any point in time there will be shares or securities that have been incorrectly priced, but such errors in pricing are completely unbiased and random, and there is no means of analysing data to correctly highlight such under or over pricing.

The Efficient Market Hypothesis closely ties in with the Random Walk Theory which claims stocks take a random and unpredictable path much like that of a drunken man left to walk around aimlessly in the middle of a field. The Random Walk Theory suggests that the path stocks follow are in no way influenced by past price movements and therefore no accurate predictions can be made about the future movement of stocks from historical data. However, a number of supporters of the theory have conceded that in the long run, markets do tend to move upwards over time. In 1973 Burton Malkiel wrote the book A Random Walk Down Wall Street which strongly supported the theory, the book provoked disapproval by many but to this day still remains on the top-seller list for finance books.

In 1970 Eugene Fama elaborated on the EMH to create a three level efficiency grading system, designed to measure the extent to which markets were efficient. The first level is known as Weak-form efficiency. Under Weak-form efficiency current share prices fully reflect all information contained in past price movements, therefore nobody can identify mis-priced shares or securities and make large returns by simply analysing past prices. It should be expected that Weak-form efficiency is in place in our markets as past share prices are easily attainable, and so no one person should be able to make exceptional returns from information that is so readily available to many, otherwise everybody would be scrutinising past share prices in order to ‘beat the market’. Empirical evidence such as that of Cootner (1962), Osborne (1962) and Fama (1965) suggest that it is very difficult to make money on publicly available information such as past price movements, due to a low degree of serial correlation and high transaction costs associated with the collection and analysing of such data.

The second level of efficiency is known as Semi-strong efficiency. Under Semi-strong efficiency current share price reflects all publicly available knowledge. This includes past prices, earnings and dividend announcements, rights issues, financial statements, merger plans, technological breakthroughs, etc. The Semi-strong efficiency assumes that all publicly available knowledge is absorbed into the share price as soon as it is released, therefore no money can be made by analysing such information. The Semi-strong level of efficiency is arguably the most controversial of all three levels due to the fact that if it is true, the work of millions of fundamental analysts would be useless, the time and money that has been spent on analysing publicly available information would have been a complete waste as all new information has already been absorbed into the share price. Unfortunately for analysts, there is much evidence to support this claim. Event studies in the 1960’s and 70’s, such of that of Ball and Brown (1968) and Davies and Canes (1978) show that, particularly after transaction costs are taken into account, there is little chance of large excess returns being earned by fund managers. The situation does not seem to have improved in recent years either. It seems that investors would have made more money by backing the index rather than investing with most individual managers, “Of the 72 active funds that outperformed the index

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