Features of Efficient Market Hypotheses and Evidences against It

Dhiraj Rai, Roll 22521

From the article entitled ‘The Efficient Market Hypothesis’ by Jonathan Clarke, Tomas Jandik,
and Gerson Mandelker, we can draw some key features of the EMH as follows:

▪ The current stock prices fully reflect all available information about the value of the firm.
When the price of stock captures every bit of information available in the market, the stock
price quickly responds to the new information.
▪ The efficient market should have large numbers of sellers and buyers of securities which
is a characteristic of a perfectly competitive market. It assumes that all investors get
information instantaneously with no costs. All investors are equally capable of analyzing
and utilizing the information.
▪ When prices go up for any favorable and positive market information, the supply of shares
will increase quickly. As a result, the stock price will not increase so much. The price
quickly adjusts to new information. There is no mis-pricing of stocks in the market.
▪ But in reality, no investors can detect mispriced stocks given the availability of quick and
complete market information. Investors predictably cannot beat the market.
▪ The EMH suggests that predicting price movement is unlikely. Technical analysis will not
help much. A passive portfolio or index-fund portfolio might perform equally well.
▪ The article has examined the three forms of the EMH. In weak form efficiency, the current
price fully incorporates information contained in the past history of prices. There is zero
correlation between the current return on a security and the return on the same security
over a previous period.
▪ In semi-strong form efficiency, the current price fully incorporates all publicly available
information. Firms should disclose financial statements along with many other non-
financial matters to shareholders while fulfilling the regulatory requirement. For Nepalese
case, the firms are required to submit information about the dividend declaration, change
in board members to NEPSE, and financials to SEBON and OCR. This information should
be available to all investors at free of costs and at the same time of interval.
▪ In strong form efficiency, the current price fully incorporates all information; both public
and private information. Private information means insiders information, not publicly

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 available at the time. The highly efficient market anticipates future developments of the
firms in an unbiased manner. The stock price takes into account any kind of anticipated
development and information which makes investors stock valuation more objective than
the insiders do. Insider information does not matter.
▪ In summing up, the EMH propounds that (1) investors can not beat the market, (2) technical
and financial analysis is pointless, (3) new information is quickly reflected in prices, and
(4) all investors are equally capable of analyzing and exploiting the new information.

Evidence Against the EMH

Research findings are inconsistent with the strong form efficiency. It partially supports the weak-
form and semi-form EMH. An article entitled ‘Does the Stock Market Overreact?’ by Werner F.M.
De Bondt and Richard Thaler investigated the investors behavior vis-à-vis their reaction to external
news events. Authors discovered the existence of market inefficiencies. Main arguments against
the EMH are as follows:

▪ Most people tend to ‘overreact’ to unexpected and dramatic news which had resulted into
high volatility of stock market.
▪ In line with overreaction proposition, the ‘prior losers’ portfolios outperformed the ‘prior
winner’ portfolios. The losing stocks were found to earn about 25% more than the winners
during 36 months period of portfolio formation. The results are against the EMH.
▪ The findings highlighted on the ‘January effect’ of returns earned by the prior losers.
Anticipated as a very unusual month for the stock market, the returns had tended to be
higher during the first two weeks of January. Losers earn exceptionally large January
returns while winners do not. The higher return wouldn’t had to appear, if the market was
efficient enough.
▪ Investors articulated their portfolio strategy to take advantage of price ‘anomaly’ caused
by the January effect.

Another article entitled the Impact of Behavioral Biases on Investors Decision Making: Male Vs
Female by Bashir, T., Rashed S.U., Fatima, S.S. and Maqsood, S.M. has presented the following
evidences against the EMH:

▪ Overconfidence bias. EMH has ignored the effect of biases in decision making process. It
assumes that people always make rational decision. But people are prone to many

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 behavioral biases and use short-cuts while making decisions. Owing to inherent bias built
in human brains, human tend to make sub-optimal decision. The research finding has
confirmed that majority of respondents (male students) were overconfident about their
ability than female student counterparts.
▪ Confirmation bias. EMH assumes that people quickly respond to any news and information
in same fashion. But the research found that people always favor the information that
confirms and support their belief compared to news that disfavor their belief.
▪ Loss aversion. According to Kahneman and Tversky (1979), people hate losses much than
they love gains. People generally have strong impulses to avoid losses than to acquire
gains.
▪ Familiarity heuristics. People assign more weightage to event which is generally most easy
to recall and familiar. In their research, 64% of respondents were found to be demonstrated
familiarity heuristics.
▪ Illusion of control. People believe they can control and/or influence outcomes at any
circumstance. The study found the existence of illusion of control among 48% of students.

Required Conditions for EMH

For the efficient market hypotheses to work for practical use, there should be legal, technical, and
information efficiency.

▪ Legal efficiency means the provision and enforcement of adequate rules and regulations to
protect investors and public money.
▪ Technical efficiency means the provision of large, secure, fast networks and other
infrastructures that support market participants to trade with huge volumes and obtain
market information instantly.
▪ Information efficiency refers to the availability of information to all investors at the same
point in time without any restrictions.

The arrival of new information is considered the main engine of price change which is the basis of
EMH. The efficient market theory has been criticized on grounds of its ignorance of many
behavioral bias and market imperfections.