The Efficient Market Hypothesis Essay

1836 words - 7 pages

The efficient market, as one of the pillars of neoclassical finance, asserts that financial markets are efficient on information. The efficient market hypothesis suggests that there is no trading system based on currently available information that could be expected to generate excess risk-adjusted returns consistently as this information is already reflected in current prices. However, EMH has been the most controversial subject of research in the fields of financial economics during the last 40 years. “Behavioural finance, however, is now seriously challenging this premise by arguing that people are clearly not rational” (Ross, (2002)). Behavioral finance uses facts from psychology and other human sciences in order to explain human investors’ behaviors.

A generation ago, it was generally believed that security markets were efficient in adjusting information about individual stocks and stock market as a whole (Malkiel, (2003)). However, we cannot deny the efficient market hypothesis has several paradoxes.

In the first place, a main theoretical cornerstone for the EMH to be a consequence of equilibrium in capital markets is that markets are always rational. This is against the realism. Even if the foregoing assumption turn out to be entirely possible, many recent studies have concluded that rationality is not always a realistic assumption as investors in many cases engage in irrational investment (Kahneman and Riepe, (1998)).

Second, the efficient market hypothesis cannot explain market anomalies. These market anomalies include the pricing/earnings effect, the size and January effect, the monthly effect, holiday effect and the weekend effect. These anomalies indicate either market inefficiency or inadequacies in the underlying asset-pricing model (Schwert, (2002)). When talking about the test on efficient market hypothesis, we know in weak-form efficiency, Fama (1965) found no evidence of abnormal returns with trading strategies based on technical analysis and concluded that security prices in most cases follow random walks. The weak-form efficiency cannot explain January effect. In semi-strong-form efficient market, to test this hypothesis, researchers look at the adjustment of share prices to public announcements such as earnings and dividend announcements, splits, takeovers and repurchases. As time goes, later tests tend to be not supportive to EMH. For instance, semi-strong-form efficiency cannot explain the pricing/earning effect. In strong-form efficiency, the highest level of market efficiency, Fama (1991) pointed out the immeasurability of market efficiency and suggested that it must be tested jointly with an equilibrium model of expected. However, perfect efficiency is an unrealistic benchmark that is unlikely to hold in practice.

Last but not least important, an efficient capital market is one in which stock prices fully reflect all available information. However, the paradox is that since...

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