How valid is Efficient Market Hypothesis and are there any better alternatives?

Throughout this blog I will discuss Efficient Market Hypothesis and will the validity using other theories.

Eugene Fama

Efficient Market Hyposthesis (EMH) was first evolved in the 1960’s by Eugene Fama. It states that all securities prices reflect all information available (due to people acting rationally to the data provided) and therefore it is impossible to beat the market – making the market ‘informationally efficient’. According to this theory there are 3 degrees to:

Weak (this reflects all past information which has been provided and the market has already reacted rationally to this information)

Semi-strong (this reflects all past and current information and market reacts instantly and rationally to new information which is published)

Strong (reflects all information including any information which may not be public - including insider information)

Fama’s EMH theory states that all security prices reflect all known information and the pricing of stocks and bonds are efficient as people have reacted rationally to the information provided and therefore have acted accordingly. In practice, most academics believe in at least the weak form of EMH (including Lars Peter Hansen who also won the Nobel Prize in 2013 alongside Fama - and agrees that markets are efficient) and numerous studies have found that prices do not move in trends based on the past. However, numerous traders dispute this theory and traders such as Michael Steinhardt and Warren Buffet have managed to beat the market which would suggest that markets are not always efficient. Therefore this would lead me to question – how valid is this hypothesis and are there any other theories which could be deemed more valid?

Robert Shiller

Robert Shiller, a third winner of the Nobel Prize in 2013, questioned EMH and stated that asset prices are too volatile to be reconciled by rationality and efficient portfolio theory. His paper "Do stock prices move too much to be justified by subsequent changes in dividends?” challenged Fama’s view of EMH and took a more behavioural approach by suggesting that people act irrationally to information and therefore share prices move accordingly. He also suggested that in a rational stock market people would base stock prices on future returns whilst also taking into account the Net Present Value of their investment.

So which of the above views are ‘more valid’?

The debate…

There appears to be supporting evidence for both theories – as previously mentioned Lars Peter Hansen and other academics believe there to be at least a weak form of efficiency in the market. Furthermore the ‘random walk’ theory supports Fama and states that you cannot predict future movements based on past trends as stock price changes have the same distribution and are independent of each other. This theory also received criticism as investors did find trends over past price movement so therefore Fama’s view of EMH is questionable. As for Shillers view, traders managing to beat the market would suggest that there is more validity in his theory.

Based on the above I think both theories can be used to a certain extent. There is evidence to show that the market reacts to past information so therefore has at least weak form of efficiency – but for traders to be able to beat the market and gain abnormally large returns there must be some inefficiency and that investors are predicting future prices (which could be based on past prices and historic movements).

http://www.morningstar.com/InvGlossary/efficient_market_hypothesis_definition_what_is.aspx

Best Advice: Fama is the Spur, Money Marketing, May 2007, pg58

Burr, B. B. (2013). Nobel award validates different market viewpoints. Pensions & Investments, 41(22), 28-n/a. Retrieved from http://search.proquest.com/docview/1447240436?accountid=12860

http://www.chicagobooth.edu/capideas/magazine/winter-2013/eugene-fama-efficient-markets-and-the-nobel-prize