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DEFINITION OF EFFICIENT MARKET HYPOTHESIS EMH An investment theory that states it is impossible to "beat the market" because stock

k market efficiency causes existing share prices to always incorporate and reflect all relevant information. According to the EMH, stocks always trade at their fair value on stock exchanges, making it impossible for investors to either purchase undervalued stocks or sell stocks for inflated prices. As such, it should be impossible to outperform the overall market through expert stock selection or market timing, and that the only way an investor can possibly obtain higher returns is by purchasing riskier investments. Read more: W4zZvro

Investopedia explains 'Efficient Market Hypothesis - EMH'

Although it is a cornerstone of modern financial theory, the EMH is highly controversial and often disputed. Believers argue it is pointless to search for undervalued stocks or to try to predict trends in the market through either fundamental or technical analysis. Meanwhile, while academics point to a large body of evidence in support of EMH, an equal amount of dissension also exists. For example, investors, such as Warren Buffett have consistently beaten the market over long periods of time, which by definition is impossible according to the EMH. Detractors of the EMH also point to events, such as the 1987 stock market crash when the Dow Jones Industrial Average (DJIA) fell by over 20% in a single day, as evidence that stock prices can seriously deviate from their fair values. Read more: W5UhDAa


When money is put into the stock market, it is done with the aim of generating a return on the capital invested. Many investors try not only to make a profitable return, but also to outperform, or beat, the market. Read more:

However, market efficiency - championed in the efficient market hypothesis (EMH) formulated by Eugene Fama in 1970, suggests that at any given time, prices fully reflect all available information on a particular stock and/or market. Thus, according to the EMH, no investor has an advantage in predicting a return on a stock price because no one has access to information not already available to everyone else. (To read more on behavioral finance, see Taking A Chance On Behavioral Finance, Understanding Investor Behavior and Mad Money ... Mad Market?)

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The Effect of Efficiency: Non-Predictability The nature of information does not have to be limited to financial news and research alone; indeed, information about political, economic and social events, combined with how investors perceive such information, whether true or rumored, will be reflected in the stock price. According to EMH, as prices respond only to information available in the market, and, because all market participants are privy to the same information, no one will have the ability to out-profit anyone else. In efficient markets, prices become not predictable but random, so no investment pattern can be discerned. A planned approach to investment, therefore, cannot be successful. This "random walk" of prices, commonly spoken about in the EMH school of thought, results in the failure of any investment strategy that aims to beat the market consistently. In fact, the EMH suggests that given the transaction costs involved in portfolio management, it would be more profitable for an investor to put his or her money into an index fund. Anomalies: The Challenge to Efficiency In the real world of investment, however, there are obvious arguments against the EMH. There are investors who have beaten the market - Warren Buffett, whose investment strategy focuses on undervalued stocks, made millions and set an example for numerous followers. There are portfolio managers who have better track records than others, and there are investment houses with more renowned research analysis than others. So how can performance be random when people are clearly profiting from and beating the market? Counter arguments to the EMH state that consistent patterns are present. Here are some examples of some of the predictable anomalies thrown in the face of the EMH: the January effect is a pattern that shows higher returns tend to be earned in the first month of the year; "blue Monday on Wall Street" is a saying that discourages buying on Friday afternoon and Monday morning because of the weekend effect, the tendency for prices to be higher on the day before and after the weekend than during the rest of the week. Studies in behavioral finance, which look into the effects of investor psychology on stock prices, also reveal that there are some predictable patterns in the stock market. Investors tend to buy undervalued stocks and sell overvalued stocks and, in a market of many participants, the result can be anything but efficient.

Paul Krugman, MIT economics professor, suggests that because of the mass mentality of the trendy, short-term shareholder, investors pull in and out of the latest and hottest stocks. This results in stock prices being distorted and the market being inefficient. So prices no longer reflect all available information in the market. Prices are instead being manipulated by profit seekers. The EMH Response The EMH does not dismiss the possibility of anomalies in the market that result in the generation of superior profits. In fact, market efficiency does not require prices to be equal to fair value all of the time. Prices may be over- or undervalued only in random occurrences, so they eventually revert back to their mean values. As such, because the deviations from a stock's fair price are in themselves random, investment strategies that result in beating the market cannot be consistent phenomena. Furthermore, the hypothesis argues that an investor who outperforms the market does so not out of skill but out of luck. EMH followers say this is due to the laws of probability: at any given time in a market with a large number of investors, some will outperform while other will remain average. How Does a Market Become Efficient? In order for a market to become efficient, investors must perceive that a market is inefficient and possible to beat. Ironically, investment strategies intended to take advantage of inefficiencies are actually the fuel that keeps a market efficient. A market has to be large and liquid. Information has to be widely available in terms of accessibility and cost and released to investors at more or less the same time. Transaction costs have to be cheaper than the expected profits of an investment strategy. Investors must also have enough funds to take advantage of inefficiency until, according to the EMH, it disappears again. Most importantly, an investor has to believe that she or he can outperform the market. Degrees of Efficiency Accepting the EMH in its purest form may be difficult; however, there are three identified classifications of the EMH, which are aimed at reflecting the degree to which it can be applied to markets. 1. Strong efficiency - This is the strongest version, which states that all information in a market, whether public or private, is accounted for in a stock price. Not even insider information could give an investor an advantage. 2. Semi-strong efficiency - This form of EMH implies that all public information is calculated into a stock's current share price. Neither fundamental nor technical analysis can be used to achieve superior gains. 3. Weak efficiency - This type of EMH claims that all past prices of a stock are reflected in today's stock price. Therefore, technical analysis cannot be used to predict and beat a market. Conclusion EMH propagandists will state that profit seekers will, in practice, exploit whatever abnormally

exists until it disappears. In instances such as the January effect (a predictable pattern of price movements), large transactions costs will most likely outweigh the benefits of trying to take advantage of such a trend. In the real world, markets cannot be absolutely efficient or wholly inefficient. It might be reasonable to see markets as essentially a mixture of both, wherein daily decisions and events cannot always be reflected immediately into a market. If all participants were to believe that the market is efficient, no one would seek extraordinary profits, which is the force that keeps the wheels of the market turning. In the age of information technology (IT), however, markets all over the world are gaining greater efficiency. IT allows for a more effective, faster means to disseminate information, and electronic trading allows for prices to adjust more quickly to news entering the market. However, while the pace at which we receive information and make transactions quickens, IT also restricts the time it takes to verify the information used to make a trade. Thus, IT may inadvertently result in less efficiency if the quality of the information we use no longer allows us to make profitgenerating decisions. Read more:

Efficient Market Hypothesis: Is The Stock Market Efficient?

Read more: An important debate among stock market investors is whether the market is efficient - that is, whether it reflects all the information made available to market participants at any given time. The efficient market hypothesis (EMH) maintains that all stocks are perfectly priced according to their inherent investment properties, the knowledge of which all market participants possess equally. At first glance, it may be easy to see a number of deficiencies in the efficient market theory, created in the 1970s by Eugene Fama. At the same time, however, it's important to explore its relevancy in the modern investing environment Read more:

Financial theories are subjective. In other words, there are no proven laws in finance, but rather ideas that try to explain how the market works. Here we'll take a look at where the efficient market theory has fallen short in terms of explaining the stock market's behavior. EMH Tenets and Problems with EMH First, the efficient market hypothesis assumes that all investors perceive all available information in precisely the same manner. The numerous methods for analyzing and valuing stocks pose some problems for the validity of the EMH. If one investor looks for undervalued market opportunities while another investor evaluates a stock on the basis of its growth potential, these two investors will already have arrived at a different assessment of the stock's fair market value. Therefore, one argument against the EMH points out that, since investors value stocks differently, it is













Secondly, under the efficient market hypothesis, no single investor is ever able to attain greater profitability than another with the same amount of invested funds: their equal possession of information means they can only achieve identical returns. But consider the wide range of investment returns attained by the entire universe of investors, investment funds and so forth. If no investor had any clear advantage over another, would there be a range of yearly returns in the mutual fund industry from significant losses to 50% profits, or more? According to the EMH, if one investor is profitable, it means the entire universe of investors is profitable. In reality, this is not necessarily the case. Thirdly (and closely related to the second point), under the efficient market hypothesis, no investor should ever be able to beat the market, or the average annual returns that all investors and funds are able to achieve using their best efforts. (For more reading on beating the market, see the frequently asked question What does it mean when people say they "beat the market"? How do they know they've done so?) This would naturally imply, as many market experts often maintain, that the absolute best investment strategy is simply to place all of one's investment funds into an index fund, which would increase or decrease according to the overall level of corporate profitability or losses. There are, however, many examples of investors who have consistently beat the market - you need look no further than Warren Buffett to find an example of someone who's managed to beat the averages year after year. (To learn more about Warren Buffett and his style of investing, see Warren Buffett: How He Does It and The Greatest Investors.) Qualifying the EMH Eugene Fama never imagined that his efficient market would be 100% efficient all the time. Of course, it's impossible for the market to attain full efficiency all the time, as it takes time for stock prices to respond to new information released into the investment community. The efficient hypothesis, however, does not give a strict definition of how much time prices need to revert to fair value. Moreover, under an efficient market, random events are entirely acceptable but will always be ironed out as prices revert to the norm. It is important to ask, however, whether EMH undermines itself in its allowance for random occurrences or environmental eventualities. There is no doubt that such eventualities must be considered under market efficiency but, by definition, true efficiency accounts for those factors immediately. In other words, prices should respond nearly instantaneously with the release of new information that can be expected to affect a stock's investment characteristics. So, if the EMH allows for inefficiencies, it may have to admit that absolute market efficiency is impossible. Increasing Market Efficiency? Although it is relatively easy to pour cold water on the efficient market hypothesis, its relevance may actually be growing. With the rise of computerized systems to analyze stock investments, trades and corporations, investments are becoming increasingly automated on the basis of strict mathematical or fundamental analytical methods. Given the right power and speed, some computers can immediately process any and all available information, and even translate such analysis into an immediate trade execution. Despite the increasing use of computers, however, most decision-making is still done by human beings and is therefore subject to human error. Even at an institutional level, the use of analytical machines is anything but universal. While the success of stock market investing is based mostly on the skill of individual or institutional investors, people will continually search for the surefire method of achieving greater returns than the market averages. Conclusion It's safe to say the market is not going to achieve perfect efficiency anytime soon. For greater efficiency to occur, the following criteria must be met: (1) universal access to high-speed and advanced systems of pricing analysis, (2) a universally accepted analysis system of pricing stocks, (3) an absolute absence of human emotion in investment decision-making, (4) the willingness of all investors to accept that their returns or losses will be exactly identical to all other market participants. It is hard to imagine even one of these criteria of market efficiency ever being met.

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Efficient market hypothesis (EMH) is an idea partly developed in the 1960s by Eugene Fama. It states that it is impossible to beat the market because prices already incorporate and reflect all relevant information. This is also a highly controversial and often disputed theory. Supporters of this model believe it is pointless to search for undervalued stocks or try to predict trends in the market through fundamental analysis or technical analysis. Read more: Under the efficient market hypothesis, any time you buy and sell securities, you're engaging in a game of chance, not skill. If markets are efficient and current, it means that prices always reflect all information, so there's no way you'll ever be able to buy a stock at a bargain price. This theory has been met with a lot of opposition, especially from the technical analysts. Their argument against the efficient market theory is that many investors base their expectations on past prices, past earnings, track records and other indicators. Because stock prices are largely based on investor expectation, many believe it only makes sense to believe that past prices influence future prices.

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The behaviour of stock prices on the Colombo Stock Exchange (CSE) is examined with a view to determine its consistency with the weak form of the Efficient Markets Hypothesis (EMH). Runs, Autocorrelation and Cointegration tests are applied to daily, weekly and monthly CSE index data for the period of January 1991November 1996. Results of Runs, Correlation and Cointegration tests overwhelmingly reject the serial independence hypothesis, leading to the conclusion that the behaviour of stock prices in the Colombo Stock Exchange is not consistent with the weak form of the Efficient Markets Hypothesis. Tests of the-day-of-the-week-effect, however, show that there is no evidence of such a phenomenon on the Colombo Stock Exchange stock prices. Results of the tests of the-month-ofthe-year-effect lead to the conclusion that CSE prices do not display any month-specific behaviour.


infrequent trading; random walk; market efficiency; emerging markets;

Gulf equity markets

Inferences drawn from tests of market efficiency are rendered imprecise in the presence of infrequent trading. As the observed index in thinly traded markets may not represent the true underlying index value, there is a systematic bias toward rejecting the efficient market hypothesis. For the three emerging Gulf markets examined in this paper, correction for infrequent trading significantly alters the results of market efficiency and random walk tests. The BeveridgeNelson (1981) decomposition of index returns is done to estimate the underlying index.


infrequent trading; random walk; market efficiency; emerging markets; Gulf equity markets

Inferences drawn from tests of market efficiency are rendered imprecise in the presence of infrequent trading. As the observed index in thinly traded markets may not represent the true underlying index value, there is a systematic bias toward rejecting the efficient market hypothesis. For the three emerging Gulf markets examined in this paper, correction for infrequent trading significantly alters the results of market efficiency and random walk tests. The BeveridgeNelson (1981) decomposition of index returns is done to estimate the underlying index.

000 A comparison of variance ratio tests of random walk : a case of asian emerging stock markets
This study re-examines the random walk hypothesis for eight emerging equity markets in Asia: Hong Kong, Indonesia, Korea, Malaysia, the Philippines, Singapore, Taiwan, and Thailand. The hypothesis is tested with two new variance ratio tests-Wright's rank and sign and Whang-Kim subsampling tests-as well as the conventional LoMacKinlay and Chow-Denning tests. We found that (i) the stock prices of the eight Asian countries do not follow random walk with the possible exceptions of Taiwan and Korea and (ii) the accelerated opening of the eight stock markets to foreign investors following the Asian financial crisis in 1997 has not significantly altered the meanreversion patterns of stock price vis--vis relative market efficiency. Our study affirms that Wright's and Whang-Kim's

tests yield far less ambiguous results as compared to Lo-MacKinlay and Chow-Denning tests. 2006 Elsevier Inc. All rights reserved.


efficiency; regulation; emerging markets; thin trading; non-linearities

Emerging markets efficiency has been widely investigated, with mixed results. However such evidence is only reliable if the methodology adopted accounts for the institutional features of the market. Unlike previous studies this paper corrects for thin trading and incorporates possible non-linear behaviour and regulatory changes. Using Istanbul Stock Exchange data we show that in its early years the exchange was characterised by non-linear behaviour and inefficient pricing. However, regulatory changes encouraged participation, improved information quality and led to prices impounding information more rapidly, suggesting markets become efficient with high trading volume, reliable information and an appropriate institutional framework.

The nature and extent of our knowledge of stock market efficiency are examined. The development of efficiency, as a way of thinking about stock markets, is traced from Roberts (1959) and Fama (1965) onward. The early work successfully introduced competitive economic theory to the study of stock markets and paved the way for a flood of empirical research on the relation between information and stock prices. This literature irreversibly altered our views on stock market behavior. The theory and evidence of seemingly-rational use of information lay in sharp contrast to prior beliefs. It was associated with a widespread increase in respect for stock markets, financial markets, and markets in general, at the time. Researchers began developing and using a variety of formal models of security prices. Nevertheless, efficiency has its limitations, both theoretically (as a way of characterizing markets) and empirically (by stretching the quality of the data, the estimation techniques used, and our knowledge of price behavior in competitive markets). Extensive evidence of anomalies suggests either that the market systematically misprices securities or that the theoretical or empirical limitations are binding, or both. The less interesting research question now is whether markets are efficient, and the more interesting question is how we can learn more about price and transactions behavior in competitive stock markets. The concept of an efficient stock market has stimulated both insight and controversy since Fama (1965) introduced it to the financial economics literature. As a construct, efficiency models the stock market in terms of the reaction of prices to the flow of information. Like all theory choices, modelling the market in this fashion involved tradeoffs. The benefits included opening the literature to an abundance of highquality researchable data, covering a variety of information, and the resulting insights obtained on the role of information in setting prices. The opportunity costs included temporarily closing the literature to alternative ways of viewing stock markets, for example by modelling public information as a homogenous

good and thus ignoring factors such as differences in beliefs among investors, differences in information processing costs, and the animal spirits that might drive group behavior. The costs also included reliance on particular asset-pricing models of how an efficient market would set prices. Not surprisingly, the ensuing deluge of research has produced some startling evidence, for and against the proposition that financial markets are efficient. Strongly-conflicting views and puzzling anomalies remain. The early evidence seemed unexpectedly consistent with the theory. The theory, and its implications, also seemed clear at the time. After a period that seems short in retrospect, the growing body of evidence in favor of the efficient market hypothesis emerged as one of the most influential empirical areas of economics. Fama's (1970) review described a flourishing, coherent and confident literature. This research had an irreversible effect on our knowledge of and attitude toward stock markets, and financial markets generally. It coincided with an emergence of interest in, and respect for, all markets among economists and politicians, and influenced the worldwide trend toward liberalizing financial and other markets. The research consistently appeared to show an unbiased reaction of stock prices to public information. The property of unbiased reaction to public information, which formed the basis of the early definitions of efficiency, was seen to be an implication of rational, maximizing investor behavior in competitive securities markets (Fama 1965, p.4). Reduced to a basic level, the reasoning was that any systematicallybiased reaction to public information is costlessly publicly observable, and thus provides pure profit opportunities to be competed away. Characterizing the market in terms of its reaction to information is only one of many feasible ways of modelling stock price behavior, but it introduced economic theoryto the empirical studyof stock prices, which had received little serious attention from economists prior to that point. Despite the subsequent spate of anomalies, the early efficiency literature not only adapted standard economic theoryto provide the first formal economic insights into how stock prices behave, but it helped pave the way for an outporing of theoretical and empirical work on stock markets and capital markets in general. Subsequent empirical research was not as consistent with the theory. Evidence of anomalous return behavior now is widespread and well-known. It generallytakes the form of variables (for example, size, day-of-the-week, P/E ratio, market/book value ratio, rank of scaled earnings change, dividend yield) that are significantly but inexplicablyrelated to subsequent abnormal stock returns. Much of this evidence has defied rational economic explanation to date and appears to have caused many researchers to strongly qualify their views on market efficiency. Disagreement has not been not confined to the evidence. The literature has produced a variety of research designs, ranging from the market model of Fama, Fisher, Jensen and Roll (FFJR, 1969) to Shiller's (1981a,b) variancebounds tests. The very term efficiency has engendered controversy: there is a modest literature on precisely what efficiency means, on the role of transaction costs, and on whether efficient markets are logically feasible. Making sense of this literature requires careful definition of efficiency in this context and careful analysis of the type of evidence that has been offered in relation to it. This involves an assessment of the strengths and weaknesses of both the theory of efficient markets, as a way of characterizing stock markets, and of the data and research designs used in testing it. Not surprisingly, a mixed conclusion emerges. While the concept of efficient markets was an audacious departure from the comparative ignorance and suspicion among economists of stock markets that preceded it, and provides valuable insights into their behavior, the concept has its limitations, in terms of both its internal logical coherence and its fit with the data. Section 1 ofthis survey sketches the development of the efficient market theory, reviewing the principal contributions in terms of their usefulness in guiding and evaluating empirical research. Section 2 addresses the limitations inherent in what is knowable about stock market efficiency, given the present state of theory about how security prices might behave in an efficient market. It argues that there are binding limitations in the theoryof asset pricing, some of which are known and others of which are unknown or even unknowable. These limitations must be borne in mind when choosing whether to interpret the data as evidence of: (1) market efficiency, under the maintained hypothesis that a specific research design, including a specific model of asset pricing used to benchmark price behavior, correctly describes pricing in an efficient market; or (2) the ability of our models and

research designs to encapsulate how prices behave in an efficient market, under the maintained hypothesis of efficiency. Against this background, section 3 then provides an assessment of the accomplishments of the theory of stock market efficiency, including an interpr