Tuesday, June 27, 2006

So long as we act inefficiently, the efficient market hypothesis will hold(?)

The efficient market hypothesis as defined on Wikipedia is as follows:

In finance, the efficient market hypothesis (EMH) asserts that financial markets are "efficient", or that prices on traded assets, e.g. stocks, bonds, or property, already reflect all known information and therefore are unbiased in the sense that they reflect the collective beliefs of all investors about future prospects. The efficient market hypothesis implies that it is not possible to consistently outperform the market — appropriately adjusted for risk — by using any information that the market already knows, except through luck or obtaining and trading on inside information. Information or news in the EMH is defined as anything that may affect stock prices that is unknowable in the present and thus appears randomly in the future. This random information will be the cause of future stock price changes.

There are three versions to this hyposthesis:

1). The Weak form: No excess returns can be earned by using investment strategies based on historical share prices or other financial data. Conclusion - Technical analysis cannot earn excess returns.

2). The semi-weak form: Share prices adjust within an arbitrarily small but finite amount of time and in an unbiased fashion to publicly available new information, so that no excess returns can be earned by trading on that information. Conclusion - Fundamental analysis will bear no fruit.

3). The strong-form:
Share prices reflect all information (inside or otherwise) and no one can earn excess returns. Conclusion - Even insiders cannot earn excess returns.


The entire article on Wikipedia rightly points to the fact that investors need not be rational for the EMH to hold or else how can one explain the excesses of the IT boom and many such booms on the yesteryears.

But if looked closely one can say that the EMH principle actually holds because market players are irrational or rather inefficient in their actions. Which means markets on the whole remain efficient so long as investors are inefficient/irrational. And, if most investors turned to index funds (believing into the efficient market hypothesis), the markets may no longer remain efficient and sustained outperformance can be achieved............hmm.......interesting (looking for more wisdom on this?)


5 comments:

Anonymous said...

Ravi

EMH was the reason that a lot pension funds and investors have moved money into S&P based indexes. These indexes are market cap weighted. There is a new type of indexing getting popular called fundamentat indexation. Look for web on it. Jeremy Seigel has also talked about it. Check for the ticker PRF and compare it with S&P :D

Tejee Tejee
http://tejee.in

Anonymous said...

Oh BTW do you know you are being syndicated at

Tejee

Asif Suria said...

Ravi,

You might find it interesting that two studies done on stock performance over a period of two decades (1975 to 1997) found that the market generally underreacted to news of stock splits. This goes in the face of the EMH.

The second study was authored by Ikenberry and Ramnath and is called "Underreaction to Self-Selected News Events: The Case of Stock Splits". I used the conclusions reached by these studies to pick Infosys and Logitech for the June edition of SINLetter.

Anonymous said...

Efficient Market Hypothesis

“I’d be a bum on the street with a tin cup if the markets were always efficient.” - Warren Buffett

Ravi Purohit said...

Personally I do not believe in the EMH and would like to believe that if one invests with patience and discipline outperforming the market is possible.

Asif: Thanks for pointing me to the article.

Tejee: Nice to know that.