Question

The Inefficiency of the Efficient Market Hypothesis

Almost half a century after it surfaced in the financial literature, the Efficient Market Hypothesis (EMH) is still taught in schools and occasionally debated in public arenas. Like most models in finance, it is what economist Robert Shiller calls a “half-truth.” The basic premise is that financial markets are so efficient at integrating information into asset prices that none has the opportunity to make profits, or “none can beat the market.” Over time, researchers have developed special versions of the EMH, including the weak, semi-strong and strong EMH, assuming various degrees of flexibility in its assumptions.

In this week’s Discussion you will critically analyze the assertions of the EMH and draw conclusions on its implications for understanding the short- and long-term dynamics of financial markets.

To Prepare

• Review this week’s Learning Resources, as well as other resources you may access from tthe Internet.

Post by Day 3 a 3- to 6-paragraph critical evaluation of the Efficient Market Hypothesis. Please make sure to include responses to the following specific questions:

• #1 To what degree do you think that the size (how much money they have) of financial market participants (investors) affects the validity of the EMH? In other words, would the EMH be more or less valid if there were many large institutional investors participating in the markets?
• #2 To what degree does the level of expertise of investors affect the validity of the EMH? For example, if every investor had a Ph.D. in Finance, would the EMH be more valid, or not?
• #3 Do you think that EMH is equally valid with all financial markets or asset categories (stocks, bonds, derivatives, mutual funds)? Why or why not? If “not,” in which markets do you believe it is least valid? Why?

Please address clearly each of the questions in 1–2 paragraphs. Make sure you use APA style for your response(s) and properly cite any resources you have used.

Answer 1

The efficient market hypothesis (EMH) is the area of research for many years because of the fact that risk-weighted return is expected to be higher in inefficient markets. In-depth understanding of market efficiency is also crucial for Investors whose decisions directly affect the valuations of the companies. The EMH is an underlying assumption in multiple financial models. In recent years, the academic and professional focus has shifted to the behavioural finance theory, yet it does not eliminate the useful­ness of the EMH.

The idea of market efficiency initially appeared in the 19th century. It reached its aca­demic maturity in the eighties, however, since then its popularity and empirical validity has declined.

The validity of EMH is directly affected by the size of investor since the investor has the ability to manipulate the price of the stock to a great extent. Say, for example, if the major Institutional Investor of Apple Inc. sells off the shares in the market, the entire market will be affected because of the combination of cognitive biases. If the investor is big, the effect on the stock market will be significant and vice versa. Hence, it has a direct impact on the market.

Argument of weak-form efficiency is a timely and accurate stock price adjustment after key announcements (i.e., mergers and acquisitions, divestitures, stock splits). The research of stock price changes after the key announcement is often referred to as “event studies”. The results of event studies have oftentimes proved the presence of semi-strong market efficiency.

Primarily, EMH assumes all investors perceive all available information in precisely the same manner. However, practically that is not the case. All investors have their own ability to analyse the data and market opportunities. Even if all the investors have one common degree, the perception to analyse the market will be different. The basic premise on which market functions is for each share sold, there is a wilful buyer to pay that price. Hence, the efficiency of EMH is not to be valid that the stock is trading currently at its fair price.

The validity of EMH is debated. The EMH is useful as a theoretical concept with which to study financial market phenomena. The EMH is equally valid with all the financial market except where the beta of the securities is zero. i.e. Bank Deposits.