The Inefficiency of the Efficient Market Hypothesis

by Madhav Kapoor

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The Efficient Market Hypothesis (EMH), also known as the efficient market theory is a hypothesis that states share prices reflect all information and consistent alpha (term used in investing to describe a strategy's ability to beat the market) generation is impossible.

According to EMH, stocks always trade at their fair values on exchanges, meaning it is impossible for investors to buy stocks that are undervalued or sell stocks that are overvalued. Therefore, it is impossible for investors to outperform the market through expert stock selection or market timing.

The proponents of the theory argue it is pointless to search for undervalued stocks or try to predict trends, rubbishing the foundational stones of investing: fundamental and technical analysis. This is because the believers of EMH argue that since the market absorbs all the information and the prices at which stocks are traded are always fair, there is no form of analysis that can help investors beat the market.

The conclusion of the Efficient Market Hypothesis is that the market is highly intellectual and it has the ability to consume all available information and factor that into the prices of securities, making it “fair.” This means that investors could do better by following a passive approach and investing in index funds.

Although it is at the center of modern financial theory, no other theory in economics or finance generates a more passionate discussion between its challengers and proponents.

Noted Harvard financial economist Michael Jensen writes “there is no other proposition in economics which has more solid empirical evidence supporting it than the Efficient Market Hypothesis,”.

Peter Lynch

On the other hand, investment maven Peter Lynch claims “Efficient markets? That’s a bunch of junk, crazy stuff.”

I believe that the EMH is highly controversial and inefficient. Why? Mainly because of the following reasons:

1. Different investors perceive information differently.

2. There is a time lag between the availability of information and the change in stock price.

3. Stock prices can be affected by human errors and misjudgments.

4. Investors have proven that they can profit from market anomalies.

Information is objective, but the way in which investors perceive this information is subjective, i.e., all investors view information differently and therefore have different stock valuations.

Investors also have different investment strategies and philosophies, which again means that investors will have different stock valuations for the same stocks.

Stock prices take time to respond to new information, i.e., there is a time lag between the two. This means once the information is available to the public, it depends on the investors how quickly they can take advantage of it.

Stock prices can also be highly affected by human behavior and emotions. On a public scale, national mood and emotions influence the stock prices and the market as a whole.

As different people have different emotions and behavior, they tend to act differently in the market, meaning some investors will profit while some will lose, making the markets highly susceptible to human behavior.

Investors can profit from market anomalies. Market anomalies are situations where some securities perform contrary to the notion of efficient markets, where security prices are said to reflect all available information at any given time.

There are a number of market anomalies; some occur and disappear while some are constantly observed. It is hard to make profit from said anomalies, but there still exists a possibility of beating the market.

In conclusion, it can be said that markets can never be fully efficient, but they can certainly move in that direction as with the rise of computerized systems to analyze stock investments, trades, and corporations, investments are becoming increasingly automated on the basis of strict mathematical or fundamental analytical methods.

Given the right power and speed, some computers can immediately process any and all available information, and even translate such analysis into an immediate trade execution.

But again, not all investors will have access to these computers, indicating some investors can benefit more than others. Therefore, markets can never be fully efficient, but they can be semi-efficient.

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References

1. https://www.turtletrader.com/efficient-market.pdf

2. https://www.avantaxwealth.com/blog/how-your-emotions-affect-stock-market#:~:text=Surprisingly%2C%20the%20reverse%20is%20true,the%20market%20as%20a%20whole.&text=Just%20as%20fear%20can%20trigger,stock%20market%20in%20a%20downturn.

3. https://www.pwlcapital.com/the-grosman-stiglitz-paradox/