Empirical Challenges of the Efficient Market Hypothesis

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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



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