Efficient Market Hypothesis - PowerPoint Presentation

1. Efficient Market Hypothesis

2. IntroductionRandom walk hypothesis The efficient market hypothesis (EMH) is an idea partly developed in the 1960s by Eugene Fama. It is an investment theory that states it is impossible to "beat the market" because stock market efficiency causes existing shares to always incorporate and reflect all relevant information. According to the EMH, stock always trade at their fair value on stock exchanges, making it impossible for investors to either purchase undervalued stocks or sell stocks for inflated prices. As such, it should be impossible to outperform the overall market through expert stock selection or market timing, and that the only way an investor can possibly obtain the higher returns is by purchasing riskier investments.

3. An efficient capital market is a market that is efficient in processing information.In other words, the market quickly and correctly adjusts to new information.In an information of efficient market, the prices of securities observed at any time are based on “correct” evaluation of all information available at that time.Therefore, in an efficient market, prices immediately and fully reflect available information.

4. Definition"In an efficient market, competition among the many intelligent participants leads to a situation where, at any point in time, actual prices of individual securities already reflect the effects of information based both on events that have already occurred and on events which, as of now, the market expects to take place in the future. In other words, in an efficient market at any point in time the actual price of a security will be a good estimate of its intrinsic value." - Eugene Fama,

5. The Efficient Markets Hypothesis The Efficient Markets Hypothesis (EMH) is made up of three progressively stronger forms:Weak FormSemi-strong FormStrong Form

6. The EMH GraphicallyIn this diagram, the circles represent the amount of information that each form of the EMH includes.Note that the weak form covers the least amount of information, and the strong form covers all information.Also note that each successive form includes the previous ones.All information, public and privateAll public informationAll historical prices and returns

7. The Weak FormThe weak form of the EMH says that past prices, volume, and other market statistics provide no information that can be used to predict future prices.Weak because security prices are the most easily available piece of information.Many financial analysts attempt to generate profits by studying exactly what this hypothesis asserts is of no value - past stock price series and trading volume data. This technique is called technical analysis. Prices should change very quickly and to the correct level when new information arrives (see next slide).This form of the EMH, if correct, repudiates technical analysis.

8. The Semi-strong FormThe semi-strong form says that prices fully reflect all publicly available information(even those reported in the financial statements of the companies) and expectations about the future.This suggests that prices adjust very rapidly to new information, and that old information cannot be used to earn superior returns.The assertion behind semi-strong market efficiency is still that one should not be able to profit using something that “everybody else knows” (the information is public). Nevertheless, this assumption is far stronger than that of weak-form efficiency. The semi-strong form, if correct, repudiates fundamental analysis.

9. The Strong FormThe strong form says that prices fully reflect all information, whether publicly available or not.Even the knowledge of material, non-public information cannot be used to earn superior results.The rationale for strong-form market efficiency is that the market anticipates, in an unbiased manner, future developments and therefore the stock price may have incorporated the information and evaluated in a much more objective and informative way than the insiders Most studies have found that the markets are not efficient in this sense.

10. Summary of Tests of the EMH Weak form is supported, so technical analysis cannot consistently outperform the market.Semi-strong form is mostly supported , so fundamental analysis cannot consistently outperform the market.Strong form is generally not supported. Ultimately, most believe that the market is very efficient, though not perfectly efficient. It is unlikely that any system of analysis could consistently and significantly beat the market (adjusted for costs and risk) over the long run.

11. Anomalies CALENDAR EFFECTS Anomalies that are linked to a particular time are called calendar effects.Weekend Effect : The tendency of stock prices to decrease on Mondays. Turn-of-the-month effect: The turn-of-the-month effect refers to the tendency of stock prices to rise on the last trading day of the month and the first three trading days of the next month.Turn-of-the-Year Effect: The turn-of-the-year effect describes a pattern of increased trading volume and higher stock prices in the last week of December and the first two weeks of January.

12. ANNOUNCEMENTS AND INFORMATIONStock split effect Short-term price drift Merger Arbitrage

13. SUPERSTITIOUS INDICATORSMuharrat TradingSuperbowl Indicator

14. Implications of Efficient MarketsTechnical Analysis –  Technical analysis uses past patterns of price and the volume of trading as the basis for predicting future prices. Evidence suggests that prices of securities are affected by news. Favourable news will push up the price and vice versa. It is therefore appropriate to question the value of technical analysis as a means of choosing security investments.

15. Fundamental Analysis – Fundamental Analysis  involves using market information(such as earnings , dividends , accounting ratios) to determine the intrinsic value of securities in order to identify those securities that are undervalued. However semi strong form market efficiency suggests that fundamentals analysis cannot be used to outperform the market. In an efficient market, equity research and valuation would be a costly task that provided no benefits. The odds of finding an undervalued stock should be random (50/50). Most of the time, the benefits from information collection and equity research would not cover the costs of doing the research.

16. Optimal Investment Strategy - For optimal investment strategies, investors should follow a passive investment strategy, which makes no attempt to beat the market. Investors should not select securities according to their risk aversion or tax positions . In an efficient market, it would be a superior strategy to have a random diversification across securities, carrying little or no information cost and minimal execution costs in order to optimise the returns. There would be no value added by portfolio managers and investment strategists .

17. The overall assumption is that no investor is able to generate an abnormal return in the market. If that is the case, an investor can expect to make a return equal to the market return. An investor should thus focus on the minimizing his costs to invest. To achieve a market rate of return, diversification in a numerous amounts of stocks is required, which may not be an option for a smaller investor. As such, an index fund would be the most appropriate investment vehicle, allowing the investor to achieve the market rate of return in a cost effective manner.