The Efficient Market Hypothesis: A Critical Review of The Literature

The Efficient Market Hypothesis:
A Critical Review of the Literature
Mehwish Naseer* and Yasir bin Tariq**
An efficient capital market is one in which security prices adjust rapidly to the arrival of new
information. The Efficient Market Hypothesis (EMH) suggests that security prices that prevail at
any time in market should be an unbiased reflection of all currently available information and return
earned is consistent with their perceived risk. Theoretical and empirical literature on EMH offers
mixed evidences. Some studies supported the hypothesis, while others have revealed some anomalies,
i.e., deviations from the rules of EMH. This review paper presents an analysis of EMH and possible
causes and evidences of anomalies. It also examines stock market efficiency in Karachi Stock
Exchange.
Introduction
A market is said to be efficient with respect to information if the price ‘fully reflects’ all
available information regarding securities. Efficient Market Hypothesis (EMH), one of the
most eminent and influential of modern financial theories, assumes that all relevant
information is rapidly incorporated in security prices as released. However researchers and
investors disagree with EMH both empirically and theoretically. The emergence of Behavioral
Finance (study of finance from the perspective of psychology and sociology) by the start of
21st century has opened new avenues of research. The focus of discussion shifted from efficient
market model to the behavioral and psychological aspects of market players. It comprehended
that unlike traditional economic theory, psychological theory could account for the
irrationality and illogicality in behaviors. It is claimed that stock prices are predictable and it
is possible to consistently and purposefully outperform a given market using these predictable
patterns. The ‘Stock Market Crash of 1987’, when the DJIA fell by over 20% in a single day,
also empirically contradicted EMH.
Supporters of behavioral finance attributed market inefficiency to the combination of
conventional economic and financial theory with behavioral psychological theories and
cognitive biases like personal judgment, overconfidence, overreaction, expectations regarding
future, word-of-mouth optimism/pessimism, ego involvement, self-esteem and self-attributed
Plz chk * Research Scholar MS (Management Sciences) Finance, Department of Management Sciences, COMSATS
a n d Institute of Information Technology, Abbottabad, Pakistan. E-mail: mehwishnaseer77@gmail.com
confirm the * * Assistant Professor, Department of Management Sciences, COMSATS Institute of Information Technology,
author info Abbottabad, Pakistan. E-mail: yasirtariq@ciit.net.pk
©
The2015 IUP. All
Efficient RightsHypothesis:
Market Reserved. A Critical Review of the Literature 1
Electronic copy available at: https://ssrn.com/abstract=2714844

biases. Calendar effects, predictable patterns of valuation parameters (P/E and B/MV ratios),
short-term momentum and tendency of returns to reverse over long run also contradict
EMH. EMH was mostly attacked on the grounds of the speed with which information is
supposed to reach market players. Critics argued that information cannot be readily
incorporated in security prices as assumed by EMH. Empirical evidences, though, have shown
mixed results, not strongly supporting EMH.
The present paper aims to review the status of EMH with special emphasis on Karachi
Stock Exchange. This review paper explains market anomalies with respect to market efficiency
and Behavioral Finance. The paper is structured as follows: it explains the EMH and the
assumptions and forms of EMH with theories related to market efficiency., followed by a
review of the existing literature regarding tests of three forms of EMH along with existence.
Subsequently, it provides evidences and possible causes of market anomalies and focuses on
previous research related to market efficiency in developing countries with special reference
to Karachi Stock Exchange. Finally, it offers the conclusion.
Author: plz
Figure 1: xxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxx
provide the
heading and
suggest where we
can mention the
figure in the text
Strong Form
(All Public and Private Information)
Semi-Strong Form
(All Public Information)
Weak Form
(All Security Market Information)
The Efficient Market Hypothesis

The EMH, one of the most accepted and eminent financial theories, stated that new
information readily incorporated in security prices and market activities or analysis of
historical and present data cannot help investors to predict future or to earn above average
risk adjusted profit. Moreover, expected return based on this price is consistent with risk,
implying that arbitrage opportunities are not viable to consistently identify and exploit.
EMH is primarily based on random walk model, according to which information comes into
market in random and unpredictable manner and price changes are thus expected to be
2 The IUP Journal of Financial Risk Management, Vol. XII, No. 4, 2015

random and independent. It is suggested that above average return is associated with above
average risk.
Efficient market hypothesis rests on three crucial arguments or assumptions:
1. Investors are assumed to be rational and value securities on the basis of maximum
expected utility.
2. If investors are not rational, their trades are assumed to be random, offsetting any
effect on prices.
3. Rational arbitragers are assumed to eliminate any influence irrational investors
have on market/security prices.
Forms of Efficient Market Hypothesis

Efficient market hypothesis can be categorized into weak form, semi-strong form and strong
form EMH. Weak form EMH is consistent with random walk hypothesis, i.e., stock prices
move randomly, and price changes are independent of each other. It states that security prices
reflect all market information regarding the security, i.e., historical price data. Therefore, it is
not possible to beat the market by earning abnormal returns on the basis of technical (trend)
analysis (where analysts accurately predict future price changes through the chart of past
price movements of stocks). According to semi-strong form EMH, prices adjusted rapidly
according to market and public information, i.e., dividend and earning announcements and
political or economic events. So it is not possible to earn abnormal returns on the basis of
fundamental analysis. Strong form EMH states that prices reflect market, public and private
information, i.e., no investor has monopolistic access to information.
Theories of Efficient Markets

Fair Game Model
Empirical literature on market efficiency also suggested that market equilibrium can be stated
in terms of expected return and equilibrium expected return is a function of risk associated
with securities; somehow it follows the Sharpe-Lintner ‘two parameter model’ and leads to
‘fair game model’. Fair game model depicts that as current prices reflect all new information,
investors trading at prevailing market prices earn a return consistent with risk. Competition
among a large number of profit-maximizing and price-sensitive investors adjusts prices rapidly
to the arrival of new information, so no investor can anticipate the information or market
pattern. Moreever, numerous and assertive transactions among a large number of traders
move the prices quickly to the new equilibrium, reflecting all new information and thus
making the market more efficient.
Submartingale
Literature also suggested that price sequences for securities follow a submartingale.
Submartingale is a fair game model which states that next period prices are expected to be
greater than current period prices, so knowledge of past events never help to predict the
future values. Trading rules based on past information cannot help investors earn above
The Efficient Market Hypothesis: A Critical Review of the Literature 3

average risk adjusted profit than a simple buy-and-hold policy.
Random Walk Model

Early studies on market efficiency were mostly based on random walk model; stock price
changes are independent of each other, having the same distribution, and so past trends or
movements cannot be used to predict future movement and it is not possible to outperform
the market without assuming risk. Random walk model as an extension of fair game model
strongly supported the independent and unpredictable pattern of information.
Literature Review
Weak Form Efficient Market Hypothesis
Weak form hypothesis assumes that security prices are adjusted rapidly on the arrival of new
market information, i.e., past price and return trends. So it is not possible for investors to
earn abnormal return on the basis of previous information. Researchers test the weak form
efficient market hypothesis through measuring autocorrelation among returns and by
examining the impact of different trading rules on stock prices.
Studies indicated that over a short time period like 1, 4, 9 and 16 days, a serial correlation
is found among returns of 30 stocks of DJIA for the period of 1957-1962. But these correlations
are always found to be equal to zero, representing a linear independency among returns and
thus consistent with market efficiency model (Fama, 1970).
In order to justify the presence of nonlinear independency among stock returns, researchers
also tested the performance of various trading rules. Y filter test that is basically ‘one security
and cash’ trading rule is approved to be consistent with Fair Game Model. Alexander (1961)
tested price indices from 1897-1959 for filters ranging from 1% to 50%.
Fama and Blume (1966) tested and compared the effectiveness of various filters to buy-
and-hold policy for Dow Jones Industrial Average’s stocks. They empirically proved that
filters cannot beat the simple buy-and-hold policy.
Although some contradictory evidence also revealed that small filters (0.5%-1%) are
inconsistent with submartingale, these filters outperform the buy-and-hold policy only if
ignoring commissions and transactions cost. Fair game model also supported market efficiency
when tested for Treasury bill market.
Osborne (1962) and Fama (1965) also used run tests to support the random walk model
and proved the independence of stock price changes over time. Security prices adjusted
rapidly on the arrival of new information. Price adjustment may be imperfect, i.e., sometimes
prices will be over-adjusted and in some cases it will be under-adjusted, but their randomness
makes unbiased adjustments.
Neiderhoffer and Osborne (1966) observed two deviations from randomness in common
stock (limit order) prices in successive transactions. In a given series of price changes, where

+ is assigned to a positive change and – to a negative change, continuation (+ + +, – – –) is
more likely to happen than reversal (+ + –, – – +). They justify this non-random behavior
by arguing that inefficiency is due to the specialist’s activity on NYSE trading floor as they
have monopolistic access to unexecuted limit orders in a given stock.
Semi-Strong Form Efficient Market Hypothesis

Semi-strong form market hypothesis is concerned with the assumption that current prices
fully reflect the publicly available information (announcement regarding earnings, dividends,
stock splits, new issues, etc. and other economic or political events). Studies revealed that
information regarding stock split is fully reflected in stock prices when actual stock split
happens. Investors cannot gain from split information once it is announced publicly (Fama
et al., 1969).
Ball and Brown (1968) used three classes of data, i.e., contents of income reports, dates of
report announcement and security price movements around announcement dates of 261
larger firms. The data obtained from Standard & Poor’s Compustat tapes examine the effect
of annual earnings announcements. Residuals from a time series regression of firm’s annual
earnings are used to classify earning as decreased or increased. Results revealed that only 10-
15% of the information regarding annual earnings announcement has been anticipated.
A similar study was conducted by Waud (1970) to measure the impact of announcement of
discount rate changes by Federal Reserve Bank. The first trading day following the announcement
depicted a statistically significant announcement effect, but the magnitude was just 5%.
Scholes (1969) examined the impact of new issues of stock and large secondary offerings
of common stock on security prices. He proved that market on the average has fully adjusted
to the information and followed a random pattern as corporate insiders needed to report to
the Security and Exchange Commission within six days of sale.
Alford and Guffey (1996) observed seasonality over two time periods: 1970 to 1994 and
1983 to 1994 in 18 countries (including the G7). ANOVA and Friedman Rank Sums were
used to analyze return data stated in terms of dollar. The data from 1970 to 1994 revaealed
some calendar effect for Canada, France, Germany, and Italy. No significant evidence was
found for seasonality in US, UK and Japan. They inferred that seasonalities may not exist and
that investors cannot utilize the patterns to predict prices. All available evidences were
found to be consistent with efficient market model.
Strong Form Efficient Market Hypothesis

Strong form market hypothesis is concerned with the assumption that all available
information is incorporated in security prices and no investor has monopolistic access to the
private information. So no investor is able to earn above average risk-adjusted profit by
anticipating the information.
Jensen (1968) used the Sharpe and Lintner model of equilibrium expected return and
analyzed the returns of 115 mutual funds for a time period of 10 years (1955-1964). As a

proxy/norm of market portfolio, he used Standard & Poor’s 500 index. He proved empirically
that regardless of the fact that fund managers, specialists and market insiders have a wide
range of business and financial contacts, no group has access to the private information and
they cannot anticipate the future returns.
Financial Market Anomalies

The literary meaning of the word ‘anomaly’ is an unusual or odd occurrence. Frankfurter and
McGoun (2001) defined anomaly as indiscretion or a deviation from an ordinary or natural
order or an extraordinary condition. According to them, anomaly is generic in nature and
applies to any underlying novelty of fact, new or unanticipated phenomenon or a surprise
regarding any theory, hypothesis or model. The presence of anomalies indicates market
efficiency. Anomalies exhibit different behaviors with respect to time; some occur only once
and then vanish, while others occur recurrently, or continuously. An anomaly represents
divergence from the currently accepted standard that is too extensive, systematic and too
fundamental to be ignored, cannot be rejected as random error or dismissed by relaxation of
the normative scheme (Tversky and Kahneman, 1986).
Latif et al. (2011) discusssed different anomalies, their causes and some behavioral aspects
of such anomalies. Anomalies are categorized into calendar anomalies(weekend effect, turn
of the month effect, year effect and January effect), fundamental anomalies (value anomaly,
low price to book, low price to earnings, neglected stocks, high dividend yield) and technical
anomalies (moving averages, i.e., buying stocks when short-run average return rises over
long-run averages and selling the stocks when short-run averages fall below the long-run
averages, trading range break, i.e., buying of a stock when the prices rise above last peak and
selling when prices fall below last trough). It is concluded that calendar, fundamental, technical
analysis and insider trading can be used to earn abnormal profit, thus negating the efficient
market hypothesis.
Value Versus Growth Anomaly

Funds with above average rate of growth and earnings are referred to as growth funds/stocks,
while those with lower than average sales and earnings as value stocks. Graham (1962)
suggested that value strategies outperform the growth strategies. According to Lakonishok et
al. (1994) the market overestimates the potential growth of growth funds, though the value
stocks perform as well compared to growth stocks .Individual investors overestimate growth
funds on two main grounds, either because of judgmental errors or they attributed future
performance to past performance or growth though that growth rate is not likely to persist in
future. Institutional investors, though, rarely make judgmental error; however they prefer
growth stocks because of sponsor’s preferences of outperforming firms. Lakonishok et al.
(1994) are of the view that time horizon is also of considerable importance and investors
favor growth stocks over value stocks as they desire above average return in a short period of
time. Some researchers attributed superior performance of value stocks to the risk factor
associated with these stocks.

Calendar Anomalies
Calendar anomalies are the anomalies related to particular time period. Researchers
documented some unusual seasonal returns like strong January return (Haugen and Jorion, Author: plz
p r o v i d e
1996), Monday Return (Fama, 1980) and around holidays return (Ariel, 1990). Patel and complete ref. as
Evans (1995) examined monthly return data of representative stock indexes for the G7 it is not there in
countries from 1960 to 2001. Stock return data exhibited a much broader seasonal pattern ref. list
A u t h o r : and found inconsistent with and efficient market theory more integrated stock markets. The
plz clarify
study revealed a significantly higher average monthly return from December through May
than from June through November and confirmed the presence of higher January effect in all
G7 countries.
Agrawal and Tandon (1994) examined five different seasonal patterns (weekend, turn of
the month, Friday, January and monthly effect), for 18 countries, including the G7, from
1971 to 1987. The results suggested a broad seasonal pattern of stock returns than the January
effect.
Chen and Chan (1997) also tested seasonality of the US financial data series for eleven
different securities (stock, bonds, bills) for the period 1926 to 1990, under controlled economic
condition. No seasonality was found in six of the eleven series, while a stronger January effect
was exhibited by small stock firms during periods of economic expansions. Chen and Chan
suggested a broader seasonal pattern of stock returns as large stocks showed strong summer
returns. A very complex and differing pattern of seasonality was demonstrated by the rest of
the series in different economic conditions across differing time intervals.
However, after the consideration of the transaction cost, these calendar effects are found
to be very small and ineffective. ‘January Effect’ (rise of prices in very early days of New Year),
seemed to disappear as soon as they got considerable publicity.
Under-Reaction and Overreaction

Wouters (2006) suggested that the security market’s over and under reaction is due to investor’s
psychological and cognitive behaviors.
Barberis and Shleifer (2003) attributed the under-reaction to the conservatism of the
investors as they remain stuck to the previous information with the expectation that the
security would behave in the same manner as it did earlier. They argued that though investors
have a propensity to react to prior information, yet not with the equivalent magnitude as the A u t h o r :
plz clarify
requisite of the underlying information.
These arguments seemed to be consistent with the conservatism described by Edwards Author: plz
p r o v i d e
(1968) as slow reaction of the investor causing the under-reaction. Another important
complete ref. as
characteristic of the human behavior known as representativeness bias is also introduced by it is not there in
Tversky and Kahneman (1986). Later on Barberis and Shleifer (2003) categorized investors ref. list
according to different investing styles on the basis of past performance, momentum effects,
contrarian strategies, etc. They also argued that representativeness bias results in overreaction

as the investor perceives the same performance in the future as demonstrated by recent
information, thus overvaluing the security, but in the long run, prices would come into
equilibrium.
Momentum Effect
‘Momentum strategies’ refer to the tendency to purchase stocks displaying positive
correlations over time with the belief that large increases in the price of a security will be
chased by additional gains and vice versa for declining values.
Hons and Tonks (2003) investigated the US stock market for some specific trading
strategies such as momentum effect, over the period 1977-1966, and proved the presence of
momentum strategies in the stock market. They concluded that returns exhibit a positive
autocorrelation for a short time period and suggested that by selling past losers and by buying
past winners investors can gain abnormal profits.
Cootner (1964) found zero correlation among stock returns, while Lo and Mackinlay
(1999) examined significant correlation among returns.
Campbell et al. (1997) examined the predictive ability of stok returns in aggregate US
share market over daily, weekly and monthly intervals and found that above average return
increaes the probability of future earning. However, later research revealed that the previous
day’s return can predict only 12% variation in daily stock price index and portfolios of small
stocks display a greater degree of predictability than large stocks. There is also some weak
evidence that the degree of predictability has diminished over time.
This positive Short-Term Momentum is also supported by ‘Head and Shoulder’ and ‘Double
Bottom’ patterns. Supporters of behavioral finance found this momentum consistent with
feedback model. They also suggested that investor’s propensity to under-react to new
information is also a major cause of such momentum (Shiller, 2003).
Reverse Pattern and Contrarian Strategies

Long run stock returns portrayed a Reverse Pattern (negative serial correlation) or mean
reversion. This long term reversal seems to be consistent with ‘Contrarian Strategies’ (an
investment strategy that goes against prevailing market trends involves buying assets that
are performing poorly) and behavioral decision theory (Tversky and Kahneman, 1986).
Reversal tendency in the intraday price movements of Chicago wheat futures was also
reported by Working (1954). He analyzed 100 successive price changes for 143 series, covering
the period 1927-1940. He reported 65 or more reversal per 100 changes in 140 of the 143
price series.
Investors’ overconfidence in their forecasting ability, word-of-mouth optimism and
pessimism and proclivity to buy neglected stocks cause prices to deviate from their fundamental
value and result in reversion (De Bondt and Thaler, 1985). De Bondt and Thaler found that
stock prices follow a continuous and positive pattern over the short term but reverse in the

long run and past losers tend to be future winners and vice versa. Such long-term reversals
were attributed to investor’s overreaction.
Jegadeesh and Titman (1993) also found that winner stock that paid high return for six
months beat loser stocks that paid low returns for the six month, but after that, for three
consecutive years the winner stock return decreased and that of the loser stock for three
consecutive years increased.
Seasoned equity earnings (Loughran and Ritter, 1997), new exchange listings (Dharan
and Ikenberry, 1995), and returns to acquiring firms in mergers (Asquith and Bruner, 1983)
were also characterized by positive long-term abnormal returns before the event and negative
abnormal returns thereafter.
Results of strong form test offer some contradictory evidences in the form of strong
market inefficiency, as pointed out by Neiderhoffer and Osborne (1966). They observed that
specialists on NYSE gain abnormal profit as they have more access to information concerning
unfulfilled limit orders. They also analyzed ticker prices of six stocks of DJIA for 22 trading
days of October 1964 to examine the random walk hypothesis prediction and correspondence
of ticker prices movements. The results suggested a general tendency of price reversal between
trades. Moreover, reversal and continuation of ticker prices can be used to infer composition
of market orders.
Though Fluck et al. (1997) found strong statistical evidence of return reversal by analyzing
two groups of stocks over a period of 13 years, later they found similar return for both groups.
Thus contrarian strategy cannot help investors to generate abnormal returns and was found
to be consistent with EMH. However, research revealed that such positive short-term
momentum cannot be translated into abnormal returns after considering the substantial
transaction cost (Odean, 1999).
Under-reaction to new information and bandwagon effect (a psychological and social
behavior where people have a propensity to go along with what others do or think without
considering their actions) is also criticized by Fama (1990). His empirical analysis of ‘Event
Studies’, which examines the impact of specific significant economic events on stock prices,
concluded that such anomalies can be explained only in the context of some particular
situations/models and behave inversely when exposed to different situations or statistical
techniques.
Price Earnings Ratios and Dividend Yield

Extensive empirical research based on time series analysis has been conducted to measure
the predictive power of valuation parameters as price earnings ratios and dividend yield.
Several studies have examined the relationship between initial dividend yield of stocks and
future stock returns.
According to Fluck et al. (1997), predictive ability of dividend yield did not work for
individual stocks. This phenomenon leads to ‘Dogs of the Dow Strategy’ (purchasing of 10
high yielding stocks of DJIA), but this strategy also failed during 1995-1999.

Similar behavior was demonstrated by Price-Earnings ratios. Campbell and Shiller (1988)
reported that low P/E stocks outperformed high P/E stocks, implying that information
regarding P/E ratios can be used to predict future abnormal returns. Other predictable time
series patterns considered were short-term interest rate spread (Campbell, 1987) and risk
spread (Keim and Stambaugh, 1986). Their predictability was found inconsistent with market
inefficiency as they reflected time varying risk premium, and over the long run, no significant
evidence was found for excess return.
Basu (1977) empirically determined relationship between price earnings ratio and
investment performance of equity securities of 1400 industrial firms traded on NYSE for the
period 1956-1971. He concluded that P/E ratios can be used to predict future investment
patterns as information regarding P/E ratio was not fully reflected in security prices as
postulated by semi-strong form of efficient market hypothesis. Results derived were found to
be inconsistent with semi-strong form market efficiency. The stocks with low P/E ratio
outperformed the high P/E securities by earning above average risk adjusted return even after
adjustment of taxes and transaction cost.
Numerous studies have supported this idea that high dividend yield stock outperforms
the market than the low dividend yield stocks. According to Yao et al. (2006), stocks with
high dividend yield and low payout ratio outperform the stocks with low dividend yield.
Analysis of P/E and market-to-book value ratio (firm’s asset-liabilities/number of shares
outstanding) also proved predictable patterns of these valuation parameters. It also raised a
question about market irrationality in the context of CAPM. CAPM failed to explain all
dimensions of risk, and three-factor model (P/BV and size as measure of risk) is a far better
benchmark for assessing anomalies (Fama and French, 1993).
Size Anomaly
Keim (1983) examined the impact of size (total market value of stock) on risk adjusted rate of
return. Small firms experienced significantly larger risk adjusted rate of return than large
firms, and this predictable pattern allowed investors to generate above average return. Thus
size effect can be interpreted as an anomaly or an indication of market inefficiency if beta is
a correct measurement of market risk as suggested by capital asset pricing model.
Fama and French (1993) pointed out a flat relationship between beta and return within
size deciles and emphasized that stock size is a better proxy for risk than beta, and so it cannot
be predicted as market inefficiency.
Other Anomalies
Another anomaly contradicting market inefficiency is Equity Risk Premium Puzzle, which
refers to the phenomenon that observed the return on stock is a few percent higher than
return of government bonds, but this anomaly also loses basis with passage of time. Speculative
economic bubbles like Stock Market Crash of 1987 (in which the DJIA fell by over 20% on a
single day), and Dot-Com Bubble were also cited as clear evidence of market irrationality.

Other illustrations of irrational pricing like Palm Pilot, Ticker Symbols Confusion and
Closed End Fund Puzzle also presented some unusual anomalies. A short sale constraint also
depicts an unusual anomaly in 2000. 3Com sold 5% shares of its subsidiary Palm at a very
high price. It is anticipated that palm shares are overpriced, so it will be decreased when the
bubble bursts. This offered a great incentive for investors to short sell palm and buy 3Com.
But Zealots won with Palm by setting high interest cost and thus prices never come down.
Firms with identical Ticker Symbols represented a positive stock price reaction (Cooper
et al., 2001). Closed End Fund Puzzle is an empirical finding that shares of closed end funds
are generally sold at a discount. Although sometimes they are sold at premium, in recent
years the discount of 10-20% has become a norm. Evidences suggested that discount on
closed end fund is indeed a proxy for individual investor’s sentiments. These anomalies
disappeared once information was made public, and such confusions and puzzles can be
explained by transaction costs and management fees.
Market Efficiency in Developing Countries with Special Reference to Karachi

Stock Exchange
Extensive research has been conducted regarding the market efficiency of developing
economies and it is found that in most of the developing countries’ financial markets, flow of
information is not symmetrical. Moreover, theoretical and empirical evidences of market
efficiency for Karachi Stock Exchange also contradicted EMH and not characterized by random
walk.
Barnes (1986) used Unit Root and Autocorrelation test to test stock market efficiency of
30 companies and six sector indexes for a period of 6 years from 1975 to 1980, listed on Kuala
Lumpur Stock Exchange. The results showed high degree of efficiency in the weak form of
market efficiency.
Hameed and Ashraf (2006) attempted to model and estimate the stock returns volatility
for the Pakistani stock market and to test for weak form efficiency. GARCH(p, q) model was
utilized to analyze the daily closing values of the KSE-100 for the period December 1998 to
March 2006. The results rejected the hypothesis of weak form efficiency as returns exhibited
volatility clustering and persistence.
Patel et al. (2011) examined the Indian stock markets (Bombay Stock Exchange and
National Stock Exchange) for weak form efficiency, from August 1998 to July 2010. For
convenience purpose, the data was divided into intervals of three years, 2001 to 2004, 2004
to 2007, and 2007 to 2010. Unit root test, autocorrelation and runs tests were used for data
analysis. The analysis revealed significant autocorrelation in the period August 2001 to July
2004, thus depicting weak form inefficiency. However, in the periods August 1998 to July
2001and August 2004 to July 2007, the market followed random walk. The period of 2004 to
2010 was found to support weak form market efficiency.
Riaz et al. (2012) employed Jarque Bera test, Kolmogorov Smirnov test, Unit root tests,
autoregressive model, run test and variance ratio test to investigate the evidence of weak

form efficiency for Karachi stock market by taking monthly index data for the period of July
1, 1997 to July 2, 2011. The concluded that rational investors can use technical analysis to
predict future trends in the short run as KSE proved to be weak form inefficient.
Mudassar et al. (2013) analyzed the random behavior of daily index of Karachi stock
Exchange (KSE 100 index) for a period of three years 2008-2011. Run test, Augmented
Dickey-Fuller (ADF) test, Phillips Perron (PP) test and autocorrelation analysis revealed
weak form inefficiency of KSE. Most of the times, investor were able to generate abnormal
profits on the basis of past information and historical trends.
Conclusion
The EMH, one of the most accepted and eminent financial theories, asserts that financial
markets are informational efficient and competition among a large number of profit-
maximizing and price-sensitive investors adjusts prices rapidly to the arrival of new
information, so no investor can anticipate the information or market pattern (Fama, 1970).
Fama categorized EMH into weak form EMH (security prices reflect all market information
regarding the security, i.e., historical price data), semi-strong form EMH (prices adjusted
rapidly according to market and public information, i.e., dividend and earning announcements
and political or economic events) and strong form EMH (prices reflect market, public and
private information, i.e., no investor has monopolistic access to the information). Historical
research on EMH is conducted in sequence from weak form test to semi-strong and strong
form test. Previous theoretical and empirical evidences strongly supported the weak form
efficient market model by filter test (Alexender, 1961; and Fama and Blume, 1966) and run
test (Fama, 1965; and Osborne, 1962). Studies were conducted by Ball and Brown (1968) to
examine the effect of annual earnings announcements, by Scholes (1969) to know the impact
of new issues of stock on security prices, and by Waud (1970) to measure the impact of
announcement of discount rates. All available evidences were found consistent with semi-
strong efficient market model. Jensen (1968) proved empirically that specialists and market
insiders have no access to private information and they cannot anticipate the future returns.
Further evidences considered strong form efficiency an ideal but somewhat unrealistic market
(Neiderhoffer and Osborne, 1966). However, since then, many researchers and investors
have disagreed with EMH both empirically and theoretically and EMH is now seen as true on
relative terms instead.
Many theoretical justifications are made to support EMH and they reported some anomalies
that contradicted market efficiency like Calendar effects (Haugen and Jorion, 1996), valuation
parameters (Campbell and Shiller, 1988) momentum effect (De Bondt and Thaler, 1985),
and size effect (Keim, 1983). Behavioral Finance attributed market inefficiency to
psychological theories and cognitive biases like personal judgment, overconfidence,
overreaction (Wouters, 2006), expectations regarding future (Barberis and Shleifer, 2003),
word-of-mouth optimism/pessimism, ego involvement, self-esteem and representativeness
bias (Tversky and Kahneman, 1986). Value investing also empirically challenged EMH
(Graham, 1962). Empirical evidences also proved Karachi Stock Exchange as weak form

inefficient, as investors are able to exploit the market by earning abnormal return on the
basis of technical analysis. Further empirical work has highlighted that predictability was
found inconsistent with market inefficiency as they reflected time varying risk premium, and
over the long run, no significant evidence was found for excess return. Moreover, these
anomalies seemed to disappear or be ineffective in the long run (Alford and Guffey, 1996) or
when information was made public (Scholes, 1969). Essentially, though the markets may
often be efficient, they are not necessarily always efficient. 
References
1. Agrawal A and Tandon K (1994), “Anomalies or Illusions? Evidence from Stock Markets
in Eighteen”, Journal of International Money and Finance, Vol. 13, pp. 83-106.
Author: plz
2. Alexander S S (1961), “Price Movemenst in Speculative Markets: Trends or Random provide the
Walks”, Industrial Management Review, pp. 7-26. missing vol.,
& issue nos.
3. Alford A and Guffey D M (1996), “A Re-examination of International Seasonalities”,
Review of Financial Economics, Vol. 5, pp. 1-17.
4. Andreassen P and Kraus S (1988), “Judgmental Predictions by Etrapolation”, Unpublished
Paper, Department of Psychology, Harvard University.
5. Ariel R (1990), “High Stock Returns Before Holidays: Existence and Evidence on Possible
Causes”, Journal of Finance, Vol. 45, pp. 1611-1626.
6. Asquith P and Bruner R F (1983), “The Gains to Bidding Firms From Merger”, Journal of
Financial Economics, pp. 121-139.
7. Ball R and Brown P (1968), “An Empirical Evaluation of Acounting Income Numbers”,
Journal of Accounting Research, Vol. 6, pp. 159-78.
8. Barberis N and Shleifer A (2003), “Style Investing”, Journal of Financial Economics,
Vol. 68, pp. 161-199.
9. Barnes P (1986), “Thin Trading and Stock Market Efficiency: The Case of the
Kuala Lumpur Stock Exchange”, Journal of Business Finance and Accounting, Vol. 13,
pp. 609-617.
10. Basu S (1977), “Investment Performance of Common Stocks in Relation to Their Price
Earning Ratios: A Test of the Efficient Market Hypothesis”, The Journal of Finance,
Vol. 32, pp. 663-682.
11. Campbell J Y and Shiller R J (1988), “Stock Prices, Earnings and Expected Dividend”,
Journal of Finance, Vol. 43, pp. 661-76.
12. Campbell J Y, Lo A W and MacKinlay A C (1997), The Econometrics of Financial Markets,
Princeton University Press, Princeton.
13. Chen C R and Chan A (1997), “From T-bills to Stocks: Seasonal Anomalies Revisited”,

Journal of Business Finance and Accounting, Vol. 24, pp. 573-593.
14. Cooper M, Rau P and Demitrov O (2001), “A rose.com by Any Other Name”, Journal of
Corporate Finance, Vol. 56, pp. 2371-2388.
15. Cootner P (1964), The Random Character of Stock Market Price, MIT Press, Cambridge,
MA. Author: plz
provide the
16. Dharan B G and Ikenberry D L (1995), “The Long Run Negative Drift of Post Listing
missing vol.,
Stock Returns”. issue & pp
17. De Bondt W F and Thaler R (1985), “Does the Stock Market Overreact?”, The Journal of nos.
Finance, Vol. 40, pp. 793-805.
18. Fama E F (1965), “The Behavior of Stock Market Prices”, Journal of Business, Vol. 38,
pp. 34-105.
19. Fama E F (1970), “Efficient Capital Market: A Review of Theory and Empirical Work”,
Journal of Finance, Vol. 25, pp. 387-417.
20. Fama E F and Blume M (1966), “Filter Rule and Stock Market Trading Profits”, Journal of
Author: plz
chk 1 or 2
Business, Vol. 39, pp. 226-41.
refs.? 21. Fama E F and French K R (1993), “Common Risk Factors in the Returns on Stocks and
Bonds”, Journal of Financial Economics, p. 33.
22. Fama E F, Fisher L, Jensen M and Roll R (1969), “The Adjustment of Stock Prices to New
Information”, International Business Review, Vol. X, pp. 1-21.
23. Fluck Z, Malkiel B and Quandt R (1997), “The Predictability of Stock Returns: A Cross-
Sectional Simulation”, Review of Economics and Statistics, Vol. 79, pp. 176-183.
24. Frankfurter G M and McGoun E G (2001), “Anomalies in Finance What are They and
What are they Good For?”, International Review of Financial Analysis, Vol. 10, pp. 407-429.
25. Graham D C (1962), Security Analysis: Principles and Techniques, McGraw-Hill, New York.
26. Hameed A and Ashraf H (2006), Alexender, S. S. (1961). Price Movemenst in Speculative A u t h o r :
Markets: Trends or Random Walks. Industrial Management Review, 7-26. The Pakistan plz clarify
Development Review, Vol. 45, pp. 1029-1040.
27. Hons M and Tonks I (2003), “Momentum in the UK Stock Market”, Journal of Multinational
Financial Management, Vol. 13, pp. 43-70.
28. Haugen R A and Jorion P (1996), “The January Effect: Still There After All These
Years”, Financial Analyst Journal, pp. 27-31.
Author: plz 29. Investment Performance of Common Stocks in Relation to Their Price Earning Ratio:
chk author A Test of the Efficient Market Hypothesis (1977), The Journal of Finance, Vol. 32,
name is missing pp. 663-682.

30. Jegadeesh N and Titman S (1993), “Returns to Buying Winners and Selling Losers:
Implications for Stock Market Efficiency”, Journal of Finance, Vol. 48, pp. 65-91.
31. Jensen M (1968), “The Performance of Mutual Funds in the Period 1945-1964”, Journal
of Finance, Vol. 23, pp. 389-416.
32. Keim D B (1983), “Size-Related Anomalies and Stock Return Seasonality: Further
Empirical Evidence”, Journal of Financial Economics, Vol. 12, pp. 13-32.
33. Lakonishok J, Shleifer A and Vishny R W (1994), “Contrarian Investment, Extrapolation,
and Risk”, Journal of Finance, Vol. 49, pp. 1541-1578.
Author: plz 34. Latif M, Arshad S, Fatima M and Farooq S (2011), “Market Efficiency, Market Anomalies,
provide the
Causes, Evidences,and Some Behavioral Aspects of Market Anomalies”, Research Journal
missing vol.,
issue & pp of Finance and Accounting, p. 2.
nos. 35. Lintner J (1965), “Security Prices,Risk and Maximal Gains from Diversification”, Journal
of Finance, Vol. 20, pp. 587-615.
Author:
38. Loughran T and Ritter J (1997), “The Operating Performance of Þrms Conducting plz clarify
Seasoned Equity”, Journal of Finance, p. 52. a n d
provide
39. Marimon R, Spear S E and Sunder S (1993), “Exceptionally Driven Market Volatility:
t h e
An Experimental Study”, Journal of Economic Theory, Vol. 61, pp. 74-103. missing
vol., &
40. Mudassar M, Ali A, Nawaz M and Shah S A (2013), “Test of Random Walk Behavior in
issue nos.
Karachi Stock Exchange”, Pakistan Journal of Commerce and Social Sciences, Vol. 7,
pp. 70-79.
41. Neiderhoffer V and Osborne M F (1966), “Marketing Making and Reversal on the Stock
Exchage”, Journal of the American Statistical Association, Vol. 61, pp. 897-916.
42. Odean T (1999), “Do Investors Trade Too Much”, American Economic Review, Vol. 89,
pp. 1279-1298.
43. Osborne M F (1962), “Brownian Motion in Stock Market”, Operation Research, Vol. 10,
pp. 345-379.
44. Patel N R, Patel B K and Ranpura D (2011), “Testing Weak Form Market Efficiency of Author: plz
provide the
Indian Stock Markets”, SSJBMIR. missing vol.,
45. Riaz T, Hassan A and Nadim M (2012), “Market Efficiency in its Weak-Form: Evidence & issue nos.
from Karachi Stock Exchange of Pakistan”, The Journal of Commerce, Vol. 4, pp. 9-18.
46. Scholes M (1969), “A Test of the Competitive Hypothesis: The Market for New Issues
and Secondary Offerings”, Unpublished Ph.D. Thesis, Graduate School of Business,
University of Chicago.
47. Sharpe W F (1964), “Capital Asset Prices: A Theory of Market Equillibrium Under
Conditions of Risk”, Journal of Finance, Vol. 19, pp. 425-442.

48. Shiller R J (2003), “From Efficient Market Theory to Behavioral Finance”, Journal of
Economic Perspective, Vol. 17, pp. 83-104.
Author: plz
49. Tversky A and Kahneman D (1986), “Rational Choice and the Framing of Decisions”, provide the
Journal of Business, pp. 251-278. missing vol.,
& issue nos.
50. Waud R N (1970), “Interpretation of Federal Reserve Discount Rate Changes: Evidence
on the”, Econometrica, Vol. 38, pp. 231-250.
51. Working H (1954), “Price Effect of Scalping and Day Trading”, Proceeding of the Chicago
Board of Trade Annual Symposium, pp. 114-139.
52. Wouters T I (2006), “Style Investing: Behavioral Explanations of Stock Market
Anomalies”, University Library Groningen.
Reference # 37J-2015-12-xx-01


The Efficient Market Hypothesis: A Critical Review of The Literature

Uploaded by

Document Information

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

The Efficient Market Hypothesis: A Critical Review of The Literature

Uploaded by

Copyright:

Available Formats

The Efficient Market Hypothesis:

A Critical Review of the Literature

Mehwish Naseer* and Yasir bin Tariq**

Electronic copy available at: https://ssrn.com/abstract=2714844