Empirical Challenges of the Efficient Market Hypothesis

Topics: Stock market, Financial markets, Financial economics Pages: 7 (2070 words) Published: October 25, 2012
Empirical Challenges to the Efficient Market Hypothesis

1. Introduction

Random walks observed in stock return series prior to the 1970s puzzled a number of financial theorists and practitioners. In 1970, this puzzle was resolved by Eugene Fama (1970) who argued that the random walks observed in the behaviour of stock return series could be attributed to market efficiency. Market efficient meant that investors could not consistently make risk-adjusted returns by making investment decisions that were based solely on past stock market information. This is because; the information was already reflected in the stock price. Following its initial proposition, the efficient market hypothesis has remained one of the most important topics of debate in the financial and economic literature. This paper provides a discussion of the empirical challenges of the hypothesis.

2. Efficient Market Hypothesis: Theory and Empirical Challenges

There are three forms of the efficient market hypothesis: (i) the weak-form; (ii) the semi strong-from; and (iii) the strong-form (Fama, 1970, 1991). The weak-form suggests that asset prices already reflect all stock market information meaning that stock market information cannot be used to make abnormal returns on a risk-adjusted based. The semi strong-from suggests that in addition to stock market information, stock prices also reflect all publicly available information such as price-to-book ratios, dividend yield, price-to-cash flow and price-to-earnings ratios. The semi strong-form means that abnormal returns cannot be made by trading on stock market data and any other information that is disclosed to the general public about stocks (Reilly and Brown, 2009). Finally, the strong-form states that security prices reflect both public and private information (Reilly and Brown, 2009).

The empirical evidence on the efficient market hypothesis is mixed. Some studies have showed that the efficient market hypothesis is valid while others have identified imperial challenges to the hypothesis. This paper will focus on the empirical challenges. One group of studies suggest that the idea that stock returns follow a random walk has no theoretical underpinning (e.g., Niederhoffer and Osborne, 1966; Lo and MacKinlay, 1988; Poterba and Summers,1988). All these studies show that stock returns do not follow a random walk as suggested by the EMH.

Other studies have shown that the hypothesis is only valid in developed stock markets. Accordingly emerging market stock returns can be predicted which raises serious concerns over the validity of the efficient market hypothesis in these markets (e.g., D’Ambrosio, 1980; Harvey, 1993; Balaban, 1995; Grieb and Reyes, 1999; Kawakatsu and Morey, 1999). The idea that stock returns can be predicted in emerging market economies has enabled investors in developed stock markets to diversify the risk of their portfolios and enhance their returns by including emerging market assets as part of their portfolios (Harvey, 1993).

Another body of research has observed the presence of stock market anomalies. For example Debondt and Thaler (1985) argue that stock markets tend to either overreact or underreact to information suggesting that the markets are not as efficient as the EMH suggests. In addition, Jegadeesh and Titman (1993) observe that stock prices tend to persist in a particular direction of movement suggesting the presence of momentum profits. These profits can be made by adopting a strategy that shorts stocks that performed poorly in the past and buying those that performed well in the past.

Another commonly documented anomaly is the observation of premiums on low market-to-book value stocks, low price-to-earnings stocks; and low price-dividend stocks (e.g., Banz, 1981; Reinganum, 1981). The documentation of premiums is also a challenge to the EMH because in an efficient market there should be no premium on a particular investment strategy....
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