8 Mart 2009 Pazar

Efficient Market Theory, EMH

"What is a cynic? A man who knows the price of everthing, and the value of nothing"-Oscar Wilde (from a Random Walk Down Wall Street)
Anyone attempting to profit from some of the abnormal returns associated with return regularities should remember that the idiot of chance will doubt less sprinkle their results with sampling errors.
Much of the research during the 1960s and 1970s was devoted to substantiating the theory of efficient markets. Despite a century and a half of thinking about the way security prices fluctuate, it was not until the early 1960s that the power of computer allowed financial economists or analysts to test their theories with massive empirical data.

Market professionals, even some academics joined the professionals, in arguing that the stock market was predictable, and hence these professionals arm themselves against the academic onslaught with one of two techniques called fundamental analysis and technical analysis.¹
The efficient markets theory makes statements about what information is reflected in security prices. The statement that market prices instantaneously and fully reflect all relevant available information is known as the Efficient Market Hypothesis (EMH).²
The efficient market theory is broken down into three hypotheses:
  • The weak form of the efficient markets hypothesis which states that security prices reflect all historical information. If this hypothesis is true, then technical analysis, which is practiced by thousands of people, would not be a worthwhile activity;
  • The semi-strong form of the efficient markets hypothesis stipulates that all public information has its effect on market prices. No valuable investment information could be gained from reading such sources as the Wall Street Journal or Standard & Poor's publications if this hypothesis is accurate;
  • The strong form of the efficient markets hypothesis requires that security prices reflect all information.
Numerous scientific empirical studies confirmed a surprisingly large number of implications of the three hypotheses, as described above. However, some anomalies that emerged over a long period of time unable to violate the efficient market theory.

Many new anomalies that discovered during the 1980s and latter were reported by the researchers. These anomalies, namely: within-the-month return patterns, sales:price ratio effects, cash-flow:price ratio effects, agency effects, earnings controversy effects, earnings surprise effects, forecasted trends in earning effects, firm-size effects, neglect effects, day-of-the week effects, time-of-the day effects, book-value-to-price ratio effects, relative strength effects, residual reversal effects, and many other anomalies were reported.

However, these highly respected financial engineering studies did not uncover any get quick-rich opportunities. The anomalies yielded additional rates of return that, if they were statistically significant, could be measured in basis points. That is; abnormal returns that could be obtained by investing in stocks with return regularities in basis point, one one-hundredth of 1 percent. Earning incremental gains that measured in basis points is not a way to get rich quick.

These anomalies are very difficult for investors to capture because of computational problems. Nevertheless, the number of persistent anomalies that have been uncovered blemishes the efficient markets theory as a descriptive of reality.
These findings do not negate the value of the efficient markets model. It is costly to implement trading strategies that are design to benefit from the anomalies in the efficient markets theory. Without the sophisticated and costly resources needed to implement these strategies, investors and financial engineers are well advised to act as if the efficient markets theory were descriptive of reality.

The efficient market theory simply says that "you cannot expect to get something for nothing"; and that, anyone attempting to profit from some of the abnormal returns associated with return regularities should remember that the idiot of chance will doubt less sprinkle their results with sampling errors.

The random walk theory also confirmed the similar conclusion:"short-run changes in stock prices cannot be predicted; that is, future steps or directions of stock prices cannot be predicted on the basis of past actions, and so investment advisory services, earning predictions, and complicated chart patterns are useless".

Both fundamental analysis and technical analysis are useless in predicting the future steps or directions of stock prices. This means that "a blindfolded monkey, bare-assed apes- throwing darts at a newspaper's financial pages could select a portfolio that would do just as well as one carefully selected by the experts".
BIBLIOGRAPHY:
1. Urem, Hakan (1998),"Essay on Economics of Finance and Investment", Middlesex University. 2. Burton G. Malkiel "A Random Walk Down Wall Street", W.W. Norton & Company publication, 1996.
3.Fama,Eugene "Effcient Capital Markets II", Journal of Finance,26, no 5 (Dec.1991).
4. Fama, Eugene "The Behaviour of Stock Market Prices", Journal of Business,38 (Jan.1965).
5. Edwin J. Elton, Gruber Martin J. "Modern Portfolio Theory and Investment Analysis", fifth edition, John Wiley & Sons Publication, 1995.
FOOTNOTES:
1 Financial analysts that immersed in complex equations and greek symbols are useless in predicting the future steps or directions of stock prices.

² If this statement is true, then it means that the market prices of securities will always equal the fair or fundamental values, or that, if market and fundamental prices are not equal, then the difference between them is sufficiently small that, given transaction costs, this difference cannot be exploited profitably. If the EMH is true, then securities markets on average will be in continues stochastic equilibrium.