“Investing in a market where people believe in efficiency is like playing bridge with someone who has been told it doesn’t do any good to look at the cards.”

Efficient Market hypothesis


Essay, 2011

19 Pages, Grade: 1


Excerpt

“In an efficient market, security (example shares) prices rationally reflect available information” ( Arnold 2005, p.684). The efficient market hypothesis (EMH) refers to share price movement with respect to available information and thus no trader will be presented with an opportunity of making supernormal profits (except by chance), therefore their profits on a share will reflect the riskiness associated with that shares (Pike and Neal 2009). However, “detailed investigations using advanced econometric techniques, larger data sets, increasingly powerful computing ability, and alternative theoretical models have in the last few years revealed a range of anomalies when the unpredictability-of - returns hypothesis is tested. Financial markets are often predictable to some extent, but the crucial question is whether this predictability can be exploited to make excess profits from trading in the markets” (Mills 1992, as cited by Coutts, 2000, p.579).

Warren Buffet, known as one of the most successful investors in history, is convinced that stock markets are inefficient. ''I think it's fascinating how the ruling orthodoxy can cause a lot of people to think the earth is flat. Investing in a market where people believe in efficiency is like playing bridge with someone who has been told it doesn't do any good to look at the cards'' (Buffet, 1984, as cited by Davis, 1990, p.4).

Buffet is referring to the fact that market price movements are often caused by emotional purchases and sales of stocks, resulting to an inefficient market, in other words, irrational market prices (Buffet, 1984). However, there are financial economists who see it the other way round. They agree with the “Efficient Market Hypothesis” which states that security prices rationally reflect only available information (Arnold, 2005, p. 684) (see fig 1) therefore inhibiting the possibility of beating the market. According to this theory, there does not exist under- or overvalued shares, only true and fair values. It is difficult to say which side is right and which side is wrong, as both are based on logical reasoning and transparent facts. This paper will therefore, evaluate both concepts using different theories and ideas from those for and those against the EMH in order to find a conclusion which is reasonable and flexible enough to support a constructive point of view (based on pragmatism) and to better understand if Buffet’s statement is true or false or maybe both.

A well-known story mocks the EMH: A financial professor was walking along a busy corridor with a student on his way to a lecture on EMH. The student noticed a 100 dollar note lying on the floor and stopped to pick it up, the professor says, “Don’t bother—if it were really a $100 bill, it wouldn’t be there. - The story well illustrates what financial economists usually mean when they say markets are efficient. Markets can be efficient in this sense even if they sometimes make errors in valuation, as was certainly true during the 1999-early 2000 internet bubble (see fig. 5) Markets can be efficient even if its participant’s show irrationality and stock prices exhibits greater volatility than can be explained by fundamentals such as earnings and dividends (Malkiel 2003).

The origin of EMH can be traced back to the work of two individuals in the 60s: Eugene F. Fama and Paul A. Samuelson who developed the concept of market efficiency from two different angles. In contrast to Samuelson’s direction of research, Fama’s (1963; 1965a; 1965b, 1970) seminal papers were based on his interest in measuring the statistical properties of stock prices, and in resolving the debate between technical analysis (the use of geometric patterns in price and volume charts to forecast future price movements of a security) and fundamental analysis (the use of accounting and economic data to determine a security’s fair value) (Lo 2004).

Fama (1970) developed three grading systems to explain market efficiency. These were based on three different forms of investment approaches which were designed to produce abnormal returns (Arnold 2005).

Weak form efficiency; current share prices reflect all information contained in past price movements and its represented as: Pt = Pt-1 + expected return + random errort . The expected return is a function of a security’s risk and the random component is due to new information, which by definition arrives randomly; hence, in a weak form efficient market, stock prices follow a random walk ,that is cannot be predicted (see fig. 2) (Hillier et al 2010).

Semi-Strong form efficiency; security prices reflect all publicly available information (examples are historical price, annual reports, mergers, dividend payment, earnings .etc) (ibid).

Strong form efficiency; security prices reflects all information (public and private (inside) information). Note that in strong form efficiency, trading on inside knowledge is illegal because it makes outsiders feel cheated (Brigham and Houston 2009).

Investments analysts who want to determine the intrinsic worth of shares based on underlining information undertake fundamental analysis, which according to Pike and Neal (2009,p.36) “is the analysis of the fundamental determinants of company financial health and future performance prospects, such as endowment of resources, quality of management, product innovation record etc”. Furthermore, they argued that in EMH, fundamental analysis will not identify under- priced shares unless the analysts can react faster than others on release of new information or they are involved in inside trading (Pike and Neal 2009).

Warren Buffet certainly disagrees with this notion and has consistently indicated (with his success as evidence) that he and his colleagues can make money in the market by identifying undervalued shares/stock. Such financial analysts/investors with highly analytical skills do earn their living by consistently examining the fundamentals of stocks, in the hope of spotting an inefficiency via an over/under priced stocks/shares, example dividend payment, forecasted

sales, P/E ratio, merger/acquisition, change in employment policy etc. (Coutts 2011).

An example was indicated by Coutts (2011) in his lecture on Capital Assets Pricing Model: If an asset has a [beta/expected return] combination on the Security Market Line (SML), the asset is fairly priced. If the [beta/expected return] combination of an asset is above the SML, the asset is under-priced (has a high return for its beta). If the [beta/expected return] combination of an asset is below the SML, the asset is overpriced (has a low return for its beta).

Competition among investors will tend to force stocks’ [beta/expected returns] towards the SML (Please see Fig.3 & Appendix 1).

However, what is efficient to one investor could be inefficient to another because he/she can interpret the information better (Warren Buffet for example).

Another approach is technical analysis which according to Pike and Neal (2009, p.36) “is the detailed scrutiny of past time series of share price movements attempting to identify repetitive patterns” - this concept relates to Chartists who rely on graphs and charts of price movements. These highly skilled analysts aim is to spot inefficiency in the market and exploit it for huge financial gains.

According to Chew (1993), studies have identified apparent market inefficiencies on specific markets at particular times examples are the weekend effect, in which there appear to be abnormal returns on Friday and relative falls on Monday. The January effect for example, (see fig 4) occurs when share give excess returns in the first few days of January (see Appendix 3).

“The problem with placing too much importance on these studies for real investments is that the moment they are identified and publicized ,there is a good chance that they will cease to exist” (Arnold 2005,p.702).

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Excerpt out of 19 pages

Details

Title
“Investing in a market where people believe in efficiency is like playing bridge with someone who has been told it doesn’t do any good to look at the cards.”
Subtitle
Efficient Market hypothesis
College
University of Bradford  (School of Management-Business School)
Course
Capital Market Investment And Finance
Grade
1
Author
Year
2011
Pages
19
Catalog Number
V183394
ISBN (eBook)
9783656079910
ISBN (Book)
9783656079774
File size
3825 KB
Language
English
Notes
Top class, excellent use of reference.
Tags
investing, efficient, market
Quote paper
Charles Ekweruo (Author), 2011, “Investing in a market where people believe in efficiency is like playing bridge with someone who has been told it doesn’t do any good to look at the cards.”, Munich, GRIN Verlag, https://www.grin.com/document/183394

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