Question

EMH says that you cannot make a return that will consistently beat the market.

However, there are behavioural and institutional reasons why that may not be the case. You should try to identify a few of those so that you can justify your attempt to beat the market. This is not a passive strategy, you are seeking out stocks to buy and stocks to sell.

Walmart beating the Market and Target beating the market.

Is the market value fair?

What are the sources of inefficiency?

Answer 1

Efficient Market Hypothesis, which forms a cornerstone of classical finance, assumed that investors were rational and were able to process all the available information (Shiller, 1999). It states that equal relevant and important information regarding a security is available to all market participants at any particular time. This information is at all times incorporated and reflected in the market price of the security which is hence closer to the intrinsic value of the security. Also, it is not possible for any investor to outperform the market in the long-term. However, there are certain market phenomenon and anomalies that the classical theory finds difficult to explain.

In the last few decades, behavioural finance has emerged as the new approach to study the capital markets in the field of modern finance. This field represents a vast paradigm of attempts to understand and explain how reasoning and psychological factors affect investor decisions and the market prices of the security. Schindler (2007) listed finance, psychology and sociology as the three cornerstones of behavioral finance. It combines principles of psychology and sociology with that of classical finance to understand the performance of the capital markets and explain the financial market anomalies.

Critics of EMH( sources of inefficiency)

Over the years, many criticisms of EMH have emerged. We’ve taken a look at just a few of the popular arguments against the theory, which include:

1. Market bubbles and crashes
2. Market anomalies
3. Behavioural economics
4. Investors have beaten the market

1.Market bubbles and crashes

Speculative bubbles occur when an asset’s price increases beyond its fair value to the extent that, when the market correction occurs, prices fall rapidly and a financial crash takes place.According to the EMH, market bubbles and financial crashes should not occur. In fact, the theory would argue they cannot exist as an asset’s price is always accurate.When a financial bubble occurs, it does not mean that there is no consensus about the price of an asset, it just means that the consensus is wrong. In the case of the 2008 financial crash, the market participants were ignoring vital market information in order to keep boosting the credit options market. This prospect goes against everything that EMH stands for.

2.Market anomalies

It describe a situation in which there is a difference between a share price’s trajectory as set out by EMH, and its actual behaviour.Market anomalies occur for different reasons, at different times and have different effects. But they all prove that markets are not always efficient, and that individuals do not always act rationally.If markets were truly rational then calendar anomalies such as the January effect, would not exist – because they have no true explanation behind them, other than that people believe they will happen.

3.Behavioural economics

Behavioural economics also goes some way to explaining the market anomalies described above. Social pressures can cause individuals to make irrational decisions, which can cause traders to make errors and take on a larger amount of risk than they otherwise would. Especially the phenomena of herding, which describes individuals ‘jumping on the bandwagon’, is evidence that not all decisions are rational and based on information.Examples for the behavioral baises are overconfidence,disposition effect,over reaction,mental accounting, regret aversion, prospect theory.

4.Investors have beaten the market

There are investors who have consistently beaten the average market. Of course, the most famous is Warren Buffett – his company Berkshire Hathaway outperformed the S&P index 73% of the time between 2008 and 2018.Buffett does not believe the EMH himself and has been a vocal critic of the passive approach to investing. Instead Buffett takes a value investing approach, which seeks to identify undervalued stocks through fundamental analysis.Buffett does concede that EMH is a persuasive enough argument that it is understandable why many investors choose index funds and ETFs. Buffett himself has never invested in an index fund.

Can investor beat the market ?

As proven by Warren Buffett, and others like him, it is possible to beat the market. However, it would completely depend on the strategy the investor put in place, how much risk willing to take on and the way in which deal on financial markets.A lot of traders and investors will recognise that certain markets are more efficient than others and build their strategy accordingly – using passive funds for highly efficient markets, and active funds for less efficient markets.

Thank you for your question.