EFFICIENT MARKET HYPOTHESIS
P. 1
Efficient Market Hypothesis: A Focused Survey of the
Empirical Literature*
Gili Yen
Chair Professor
Dept. of Finance and Dept. of Business Administration
Nai Kai Institute of Technology
(on leave from Chaoyang Univ. of Tech.)
168 Jifong E. Rd., Wufong Township, Taichung County 41349, Taiwan, R.O.C.
Tel: 886-4-23323000#4351
Fax: 886-4-23742359
E-mail: gyen@cyut.edu.tw
Cheng-Few Lee
Distinguished Professor
Faculty of Management
Rutgers University, Piscataway
NJ 08854-8054, USA
E-mail: lee@rbmail.rutgers.edu
* Prepared for the 15th PBFEA Conference to be held in Vietnam on July 20th – 21st,
2007. The authors would like to express their heartfelt thanks to Dr. Alice C.
Lee for her valuable comments, to Professor Chi-fan Lee for stylistic suggestions,
and to students enrolled in my 2005 class of “Topics in Financial
Management”at Graduate Institute of Finance, Chaoyang University of
Technology for hearing out the arguments. Although the author makes every
effort to give credit when credit is due, he asks for forgiveness for any inadvertent
omissions.
EFFICIENT MARKET HYPOTHESIS
P. 2
ABSTRACT
Efficient Market Hypothesis (EMH), which deals with the informational efficiency of the capital
market, is one of the most thoroughly tested hypotheses in finance. Nonetheless, it remains an
unresolved empirical issue as to whether the capital market satisfies the notion of market efficiency.
In this review article, after delineating its historical origin of the EMH, the author summarizes the
empirical findings of the past four decades bearing on the EMH under the headings “supporting
empirical findings as documented in 1960’s”, “mixed empirical findings as merged in the late 1970’s
through 1980’s”, and “challenging empirical findings as appeared in 1990’s”.
The author moves on to
sketch the on-going debate in the 21st century and then present an overall assessment of the EMH.
At
the end of the article, once necessary reservations and precautious interpretations are taken, the author
argues that the EMH is here to stay and will continue to play an important role in modern finance for
years to come.
Keywords: Efficient Market Hypothesis (EMH); The Historical Origin of the EMH; Empirical
Evidence Bearing on the EMH; An Overall Assessment of the EMH
EFFICIENT MARKET HYPOTHESIS
P. 3
Efficient Market Hypothesis: A Focused Survey of the
Empirical Literature
Gili Yen
I. Introduction
In a modern society, especially a capitalistic one, there is some form of
capital market to serve as a bridge between fund providers and fund
demanders. Specifically in the corporate sector, either through direct
financing（e.g., issuing financial instruments to the public）or through indirect
financing (e.g., borrowings via financial intermediaries), collective funds are
made available to business concerns, and, then, channeled into productive uses.
Viewed from such perspective, the efficiency of capital market has always
been a source of concern.
Other than allocative efficiency, it should be
pointed out at the outset it is the capability of processing information of the
financial markets that captures the attention of scholars, practitioners, and
regulators.
And, thus, it is information efficiency that constructs the focus of
our discussions. Moreover, be it that the views come either from the
proponents who believe the capital market possesses full informational
efficiency or from the opponents who believe the capital market possesses
EFFICIENT MARKET HYPOTHESIS
P. 4
only limited information efficiency, the discussions are primarily addressed to
the stock market presumably for the following three reasons: In the first place,
the pioneering researchers in this area have documented the price behavior of
the stock market to advance the ideas of information efficiency.
Secondly,
stock market in a large number of societies is the earliest developed capital
market and remains to be the predominant form among many societies to date.
Thirdly, the stock, as a means of financing, shares similar characteristics with
other financial instruments. So the inferences drawn from the observed
empirical patterns of the stock markets with necessary modifications are
equally applicable to other types of financial instruments as well.
Consequently, in the materials to follow, the author heavily relies on the stock
market to scrutinize the notion of “Efficient Market Hypothesis (hereafter
EMH).”
To start off, it may sound superfluous to point out the informational
aspect constructs the focus of discussions. Without a doubt, the stock market
which is composed of numerous players on both demand and supply sides
with transaction taking place on a daily basis should be able to handle
EFFICIENT MARKET HYPOTHESIS
P. 5
informational flow as well as, if not better than, other markets. Clearly, when
the informational aspect attracts our attention, the issue is not whether the
stock market is capable of processing the newly arrived information but is
whether the stock market is capable of processing the newly arrived
information in a particular way insofar as the movements in stock prices are
concerned. Generally speaking, the notion that the stock satisfies information
efficiency means any newly arrived information to the stock market will be
fully and quickly reflected in the present stock prices.
In viewing that the EMH is one of the most thoroughly tested empirical
propositions in finance literature, it is virtually impossible for the author to go
through the major empirical studies, let alone all the empirical ones.
More
importantly, there are already a number of excellent surveys addressed to
EMH. All considered, the present survey attempts a bird’s eye view of
empirical studies with focuses in chronological order. Specifically, the
overriding objective of the present such survey is threefold: First, the present
survey describes briefly the historical origins of the EMH so that the readers
can understand how testable implications drawn from the EMH are later
EFFICIENT MARKET HYPOTHESIS
P. 6
developed. Second, the present survey provides a chronological review of
empirical evidence in last four decades bearing on the EMH under salient
headings so that the readers can grasp the thrust of the heated debate and
capture how the nature of debate evolves over time between the pros and the
cons of the EMH.
Finally, the present survey provides an overall assessment
of the huge body of empirical studies on EMH so that the readers can make an
educated guess as to in which direction the EMH might be headed. The
remaining sections of the present survey are organized in the following
manner: Section 2 describes the historical origin and the development of
hypothesis formulation of the EMH.
From Sections 3 through 5, empirical
evidence bearing on the EMH based on a careful review of representative
surveys, journal articles, books, and book reviews will be presented under
three headings: (1) Supporting empirical evidence on the EMH in 1960’s is
reviewed in Section 3. Mixed empirical findings for and against the EMH in
the late 1970’s through 1980’s are summarized in Section 4. Challenging
empirical evidence against the EMH as appears in 1990’s is provided in
Section 5. Then, finally in Section 6, the present survey makes an overall
EFFICIENT MARKET HYPOTHESIS
P. 7
assessment, including the on-going debate in the 21st century with regard to
the EMH, to conclude the paper.
II. Tracing the Historic Origins and Hypotheses Formulation of the EMH
A few words about the historical origin and the development of
hypotheses formulation are in order.
Over a century ago, Bachelier (1900)
when studying the mathematical theory of random processes speculated that
the movement of stock prices followed a Brownian motion.
The idea was
picked up some fifty years later by a statistician, Maurice G. Kendall. Kendall
（1953）documents that the prices of stock and commodity seems to follow a
random walk.
Following Samuelson（1965）and Mandelbrot (1966), Fama (1970)
formally defines three levels of market efficiency to guide empirical studies
and distinguish one from the other by the degree of information reflected in
stock prices in an ascending order: Information contained in the past stock
prices relevant to the firm under analysis will be fully and quickly reflected in
its present stock price, known as the weak form market efficiency. Information
contained in publicly available information relevant to the firm under analysis
EFFICIENT MARKET HYPOTHESIS
P. 8
will be fully and quickly reflected in its present stock price, known as the
semi-strong form market efficiency. All information—be it made in public or
privately held—relevant to the firm under analysis will be fully and quickly
reflected in its present price, known as the strong-form market efficiency.
III. Supporting Empirical Evidence on the EMH in 1960’s
Discussions on empirical findings as presented in this subsection
primarily come from Fama(1965) and Fama (1970) .
Fama (1965), after reviewing empirical studies conducted around 1960
asserts that the EMH has gained a strong empirical support in the following
succinct way:
The main concern of empirical research on the random walk
model has been to test the hypothesis that successive price
changes are independent.
Two different approaches have been
followed. First there is the approach that relies primarily on
common statistical tools such as serial correlation coefficients and
analyses of runs of consecutive price changes of the same
sign. ...The second approach to testing independence proceeds
EFFICIENT MARKET HYPOTHESIS
P. 9
by testing directly different mechanical trading rules to see
whether or not they provide profits greater than buy-and-hold.
Research to date has tended to concentrate on the first or
statistical approach to testing independence; the results have been
consistent and impressive.
I know of no study in which standard
statistical tools have produced evidence of important dependence
in series of successive price changes.
…As for the second
approach (italics added), [i]t seems, then, that at least for the
purposes of the individual trader or investor, tests of the filter
technique also tend to support the random walk model. (p.77 and
p.78)
Fama (1970), after reviewing empirical studies conducted in 1960’s
under the following three headings, a）weak form tests of the efficient market
models, b）tests of martingale models of the semi-strong form, and c) strong
form tests of the efficient market models, summarizes the supporting empirical
evidence for the EMH under his review in the following succinct way:
And we shall contend that there is no important evidence against
EFFICIENT MARKET HYPOTHESIS
P. 10
the hypothesis in the weak and semi-strong form tests（i.e., prices
seem to efficiently adjust to obviously publicly available
information）, and only limited evidence against the hypothesis in
the strong form tests（i.e., monopolistic access to information
about prices does not seem to be a prevalent phenomenon in the
investment community）. （p. 388）
In other words, in the heyday of EMH, with the two possible exceptions
of Niederhoffer and Osborne’s (1966) findings pointing out that specialists on
the New York Stock Exchange apparently take advantage of their monopolistic
information and of Scholes’（1969）findings indicating that the officers of
corporations sometimes have monopolistic access to information about their
firms, all evidence points to the support of the EMH, at least, in its weak and
semi-strong forms.1
On the other hand, it should be pointed out that the challengers of the
EMH with the aid of hindsight argue that a testing bias has led to the lacking
of empirical evidence in 1960’s against the EMH.
LeRoy(1989) writes:
EFFICIENT MARKET HYPOTHESIS
P. 11
Apparently when the evidence is favorable, market efficiency is
supported, but when the evidence is unfavorable, market
efficiency is treated as part of the maintained hypothesis,
insulated from falsification.2 (p.1614)
IV. Mixed Empirical Evidence on EMH in the Late 1970’s through 1980’s
To give readers some ideas of what’s going on during the period from
late 1970’s through 1980’s, the author will start with the editorial note written
by Editor Michael Jensen to the special issue of Journal of Financial
Economics（Vol. 6, 1978）.
Jensen (1978) writes:
I believe there is no other proposition in economics which has
more solid empirical evidence supporting it than the Efficient
Market Hypothesis. …Yet, in a manner remarkably similar to that
described by Thomas Kuhn in his book, The Structure of Scientific
Revolutions, we seem to be entering a stage where widely
scattered and as yet incohesive evidence is arising which seems to
be inconsistent with the theory.… It is evidence which we will
EFFICIENT MARKET HYPOTHESIS
P. 12
not be able to ignore.（p. 95）
It is also in the same special issue that Jensen raises the problem of
the joint hypothesis testing. Jensen (1978) writes:
In most cases our tests of market efficiency are, of course, tests of
a joint hypothesis; market efficiency and, in the more recent tests,
the two parameter equilibrium model of asset price determination.
The tests can fail either because one of the two hypotheses is false
or because both parts of the joint hypotheses are false.（p. 96）
In fact, Keane(1986) suggests that we treat the publication of the 1978
special issue of Journal of Financial Economics as a watershed.
Keane(1986)
writes:
Since 1978, however, when a special edition of the Journal of
Financial Economics was devoted exclusively to anomalous
findings, the flow of high-quality research studies reporting
contrary evidence has accelerated.
(P.58)
According to Keane (1986), [t]his accumulation of anomalous evidence
EFFICIENT MARKET HYPOTHESIS
P. 13
recently prompted D’Ambrosio (1984), the editor of Financial Analysts
Journal, to observe3:
Enter an abundance of idiosyncrasies ― small firm effect,
turn-of-the-year effect, low price-earnings ratio, junk bonds
(stocks?), low-priced stocks, the Value Line phenomenon,
weekend effects, performance of low beta portfolios, sector
rotation, and information coefficients.4
Documented
idiosyncratic market phenomena, like crocuses, herald a new
season. The question is: How long can the EMH continue,
unrevised, against the burgeoning list of idiosyncratic
phenomena?5(p.58)
There are eight research works in the 1978 special issue of Journal of
Financial Economics.
In what follows, the author of the present survey
summarizes the way of testing and its associated empirical findings of each
piece in Table 1.6
EFFICIENT MARKET HYPOTHESIS
P. 14
Table 1. A Tabulation of the Eight Studies in JFE (1978)
Author
Ball(1978)
Watts(1978)
Subject under
examination
Stock price
reaction to
earnings
announcements.
Stock returns in
response to
quarterly earning
announcements.
Empirical
data
Major findings
Remarks
Evidence
contained
in 20
previous
The
post-announcement risk
adjusted
The author
attributes the
anomalous
evidence to the
studies.
abnormal
returns are
systematically
no-zero.
inadequacy in the
asset pricing model.
The
earnings
for the 75
quarters
from
January,
Statistically
significant
abnormal
returns after
taking all the
steps suggested
The author
concludes that the
abnormal returns
are due to market
inefficiencies and
not asset pricing
1950
through
September,
1968
obtained
from
Moody’s
and the
Wall Street
Journal
by Ball(1978).
model deficiencies.
Index.
EFFICIENT MARKET HYPOTHESIS
P. 15
Thompson(1978)
Information
contents of
discounts and
premiums on
closed-end
funds.
1940-1971
There is a
trading rule,
based on
discounts for
closed-end
funds can earn
investors
abnormal
returns of 4%
The author argues
that the abnormal
returns are likely to
be caused by the
inadequacy of the
asset pricing model.
per year.
Besides, the
results are quite
uniform
throughout the
period.
Galai(1978)
Testing the
boundary
conditions for
The main
body of
data
The NYSE and
the CBOE do
not behave as a
The author argues
that most of the
small average profit
Chicago-BoardOptions
Exchange-Listed
options.
consists of
daily prices
for each
option
traded on
the CBOE
for the 152
trading
days from
April 26,
single
synchronized
market. In
addition, he
finds there is a
profit-making
trading rule.
would be wiped out
by transactions
costs for
non-members of the
CBOE.
1973, to
November
30, 1973.
EFFICIENT MARKET HYPOTHESIS
P. 16
Chiras &
Manaster(1978)
The information The
content of option common
prices.
stocks on
the NYSE
over the
period
1947-1967.
Comparing the
option prices
inferred from
the
Black-ScholesMerton model
and actual
option prices to
calculate
In viewing the
continuing
existence of
abnormal profits for
both members and
non-members of
CBOE, the authors
conclude that the
CBOE market is
implied
variances of
future stock
inefficient.
returns.
A trading
strategy that
utilizes the
information
content of the
implied
variances yields
abnormally high
returns and the
returns appear
to be high
enough to allow
profits even for
non-members of
the exchange.
EFFICIENT MARKET HYPOTHESIS
P. 17
Long(1978)
Charest(1978a)
The history of
relative prices of
two classes of
stock of the
Citizens Utilities
Company. The
two classes are
virtually
identical in all
1956-1976
The evidence
indicates the
market prices
assets in such a
way that it
places a slight
premium on
cash dividends
over capital
respects except
for dividend
payout: one pays
gains, which
runs the
opposite
only stock
dividends; and,
the other pays
only cash
dividend.
direction to that
predicted by
straightforward
consideration of
tax effects.
Stock returns in
response to the
proposals,
approvals and
realization of
stock splits.
1947-1967
The author, similar
to Ball (1978) and
Thompson(1978),
attributes the
anomalous finding
to the inadequacy in
the asset pricing
model.
The evidence
The author
from the stock
spilt study
shows some
indication of
non-zero
abnormal
returns, but they
are sensitive to
the precise
estimation
concludes that the
evidence on market
price adjustment to
stock splits is
generally consistent
with market
efficiency.
techniques used
and the
particular time
interval
covered.
EFFICIENT MARKET HYPOTHESIS
P. 18
Charest(1978b)
Stock returns in
1947-1967
response to the
announcement
of cash dividend.
The evidence
from the cash
dividend
announcement
study reveals
significant
abnormal
returns in the
months
The author
concludes that the
evidence is
inconsistent with
the join hypothesis
that the market is
efficient in the
Semi-strong Form
sense and that asset
following
dividend
changes.
price determination
is adequately
described by the
Furthermore,
unlike the split
results, the
abnormalities
are not sensitive
to estimation
two parameter
model. The
author, however, is
unable to determine
the exact cause of
the abnormal
methods.
returns.
Source: Prepared on the basis of Jensen’s (1978) editorial note in Journal of
Financial Economics, 6, pp.95-101.
In sum, the following empirical patterns emerge in this special issue:
Four studies report empirical findings running against the EMH; one study
views its empirical findings as consistent with the EMH; and, three studies
report empirical findings which can be viewed as either consistent or
inconsistent with the EMH.7 Suffice it to say that empirical studies question
the validity of the EMH begin to appear.
EFFICIENT MARKET HYPOTHESIS
P. 19
On the other side of the coin, representing the proponents of the EMH,
Fama (1991) comes to its strong defense.
Fama (1991), after reviewing
empirical studies conducted after the publication of his 1970 article under the
following three headings, a）weak form tests of the efficient market models to
be expanded to include “the predictability of returns”, b）tests of martingale
models of the semi-strong form relabeled “event studies”, and c) strong form
tests of the efficient market models relabeled “tests for private information”,
summarizes the supporting empirical evidence for the EMH in the following
succinct way:
The joint-hypothesis problem is more serious. Thus, market
efficiency per se is not testable.
It must be tested jointly with
some model of equilibrium, an asset-pricing model.
…Does the
fact that market efficiency must be tested jointly with an
equilibrium-pricing model make empirical research on efficiency
uninteresting?
Does the joint-hypothesis problem make
empirical work on asset-pricing models uninteresting?
These are,
after all, symmetric questions, with the same answer. My
EFFICIENT MARKET HYPOTHESIS
P. 20
answer is an unequivocal no. The empirical literature on
efficiency and asset-pricing models passes the acid test of the
scientific usefulness.
It has changed our views about the
behavior of returns, across securities and through time.
Indeed,
academics largely agree on the facts that emerge from the tests,
even when they disagree about their implications for efficiency
(emphasis added).
The empirical work on market efficiency and
asset-pricing models has also changed the views and practices of
market professionals. (p.1576)
Tests on the weak from of the EMH are first reviewed. (Italics
added) The evidence discussed below, that the variation through
time in expected returns is common to corporate bonds and stocks
and is related in plausible ways to business conditions, leans me
toward the conclusion that it is real and rational.
…Still, even if
we disagree on the market efficiency implications of the new
results on return predictability, I think we can agree that the tests
enrich our knowledge of the behavior of returns, across securities
EFFICIENT MARKET HYPOTHESIS
P. 21
and through time. (p.1577)
Event studies are discussed next, but briefly. (Italics added.)
Detailed reviews of event studies are already available, and the
implications of this research for market efficiency are less
controversial.
Event studies have, however, been a growth
industry during the last 20 years. Moreover, I argue that,
because they come closest to allowing a break between market
efficiency and equilibrium-pricing issues, event studies give the
most direct evidence on efficiency. And the evidence is mostly
supportive. (p.1577)
Finally, tests for private information are reviewed. (Italics added.)
The new results clarify earlier evidence that corporate insiders
have private information that is not fully reflected in prices.
The
new evidence whether professional investment managers (mutual
fund and pension fund) have private information is, however,
murky, clouded by the joint-hypothesis problem. (p.1577)
EFFICIENT MARKET HYPOTHESIS
P. 22
Relatedly, in answering the self-imposed question “Can we conclude
that markets are efficient?”, Ball (1994) expresses a middle way view:
The answer is both yes and no. On the one hand, the research
provides insights into stock price behavior that were previously
unimaginable.
On the other hand, the theory of efficient markets
(like all theories) is an imperfect and limited way of viewing
stock markets, as research has come to show. (p.33)
All considered, in view of the mixed empirical findings appearing in the
late 1970’s through 1980’s, both the “pros” and “cons” camps have come up
with solid, yet, unsettling empirical evidence bearing on the EMH.
V. Challenging Empirical Evidence on EMH in 1990’s
At this juncture, we come to empirical studies in most recent years.
Viewed from the time perspective, a group of researchers ― formed under the
nomeclature “behavioral finance” and equipped with mounting anomalous
evidence inconsistent with the EMH ― argues that the EMH paradigm be
replaced by a behavioral finance approach.
To save space, I will summarize
EFFICIENT MARKET HYPOTHESIS
P. 23
the major contributions of the nascent school as represented by Thaler (1993),
Haugen (1999), and Schleifer (2000).8
First, let us describe the contributions of Thaler (1993), ed., Advances in
Behavioral Finance.
According to Fridson (1994), the abovementioned book has made
the following major contributions: Advances in Behavioral
Finance shows that the assault on the efficient market hypothesis
has progressed well beyond the identification of minor anomalies.
Indeed, it is possible at this stage to discern three distinct forms of
the alternative paradigm. (Note that neither editor Richard H.
Thaler of Cornell University nor his contributors employ this
particular taxonomy.) (Fridson’s (1994) emphasis)
● Weak form: Some market participants fail to fulfill economists'
notions of rational behavior. The resulting distortions, by and
large, disappear quickly through the actions of arbitragers who
employ correct pricing models.
EFFICIENT MARKET HYPOTHESIS
P. 24
● Semi-strong form: Persistent analytical errors occur on so vast
a scale that prices frequently diverge materially and for protracted
periods from their correct levels.
● Strong form: Securities prices bear little relation to
corporations' financial performance. Rather, changes in market
levels are driven largely by popular manias. (p.87)
All in all, Advances in Behavioral Finance is a penetrating
investigation of a paramount investment question. …Even with
these peccadilloes (Fridson is referring to the misspelling of Peter
Bernstein’s surname and typographical errors. (italics added)),
though, Advances in Behavioral Finance represents an important
step toward accurately gauging the efficiency of capital markets.
(p.88)
Second, in the preface to the unorthodox book, The New Finance: The
Case Against Efficient Markets. Haugen (1999) writes9:
The Efficient Markets Paradigm is at the extreme end of a
EFFICIENT MARKET HYPOTHESIS
P. 25
spectrum of possible states. As such, the burden of proofs falls on
its advocates.
It is their burden to deflect the stones and arrows
flung at the paradigm by the nonbelievers. (Ibid., Preface）
After reviewing more recent empirical studies, Haugen (1999)
summarizes the implications drawn from the empirical findings against the
EMH as follows:
●
Players in today’s stock market persistently make a
fundamental mistake—overreacting to records of success and
failure on the part of business firms. … Those who recognize the
mistake can build stock portfolios, or find mutual funds, which
will subsequently outperform the market averages.
●
Owing to the foregoing mistake, the stocks that can be expected
to produce the highest returns in the future are the safest stocks.
Risky stocks can be expected to produce the lowest returns!
●
Because of agency problems in the investment business, the
opportunity there now is likely to remain there in the future.
EFFICIENT MARKET HYPOTHESIS
P. 26
●
Once we accept the assertion that corporations face an
inefficient and over-reactive capital market, many of the
long-accepted principles of corporate finance need to be amended
and revised. (Ibid., Preface)
Third, let us discuss the contributions of Schleifer as embodied in
Schleifer(2000), Inefficient Markets: An Introduction to Behavioral Finance.10
In evaluating Schleifer (2000), Koonce (2001) writes,
Inefficient markets begins with an assessment of the strength of
the three basic assumptions underlying the traditional theory of
efficient markets. First, investors are rational.
Second, to the
extent they are not rational, their behaviors are random and
therefore cancel out in the aggregate without affecting prices.
Third, to the extent that investors are systematically irrational,
there are rational arbitragers who eliminate their influence on
prices. Schleifer concludes that these assumptions may be
substantially weaker than is generally believed and lays out the
EFFICIENT MARKET HYPOTHESIS
P. 27
research that calls them into question. (p.461)
According to Koonce (2001) once again, Schleifer (2000) comes
up with answers with respect to the above-listed three crucial
assumptions as follows:
Regarding the rationality of investors, Schleifer (2000) describes
a wealth of behavioral finance research showing, for example,
that investors are not Bayesin and that their judgments and
decisions are systematically influenced by how a problem is
framed.
Further, he provides evidence that these individual
behaviors are systematic (i.e., not random), thereby laying the
groundwork for his development of a theory of investor sentiment,
which he argues is one of two essential inputs to behavioral
finance theory. (The other essential input to behavioral finance
theory is the limited opportunities of arbitrage. See relevant
discussions below. (Italics added) ) Schleifer (2000) discusses
much of the research on under- and over-reaction to information
(including some research done in accounting), and reviews the
EFFICIENT MARKET HYPOTHESIS
P. 28
evidence suggesting that these market regularities are due to the
behavioral heuristics of representativeness and conservatism.
(p.461)
Schleifer (2000) spends a large portion of the book discussing
what he considers to be the other essential element of behavioral
finance theory―limited arbitrage opportunities. Drawing on his
and others’ research, he makes a convincing case as to why
real-world arbitrage is far from perfect.
…Overall, Schleifer
(2000) nicely develops and supports his argument that effective
arbitrage is limited in many real-world situations, thereby
undercutting a basic assumption of the efficient market hypothesis.
(p.461)
In a nutshell, the school of behavioral finance argues that the
inefficiency of the capital market is the norm rather than the exception.
On the other side of the coin, representing the proponents of the EMH,
Fama (1998) comes to its strong defense.
Fama (1998) writes in the abstract:
EFFICIENT MARKET HYPOTHESIS
P. 29
Market efficiency survives the challenge from the literature on
long-term return anomalies. Consistent with the market
efficiency hypothesis that the anomalies are chance results,
apparent overreaction to information is about as common as
underreaction, and post-event continuation of pre-event abnormal
returns is about as frequent as post-event reversal.
Most
important, consistent with the market efficiency prediction that
apparent anomalies can be due to methodology, most long-term
return anomalies tend to disappear with reasonable changes in
technique. (p.283)
Proponents of the EMH also provide other defenses along the following
three lines:
First, Nichols (1993), in her opinion about the behavioral finance,
writes:
The passionate critiques of CAPM and EMH notwithstanding, no
one has come up with a workable alternative.”(p.60)
EFFICIENT MARKET HYPOTHESIS
P. 30
Second, Conrad (1995), in his review of Haugen (1995), writes:
The author has attempted to rebundle several “stones and arrows”
into one package to lob at the Zealots, but he has a tendency to
state “facts” which are in fact “debates” (in other words, the
target has moved in the meantime.) (Conrad’s (1995) emphasis)
Misguided as the Zealots’ assumptions may appear to the author, I
suspect that they will continue in their attempts to develop better
asset pricing models to explain the anomalies, or better statistical
models to asses their significance.”(p.1352)
Third, Shanken and Smith (1996), quoting the comments made by Roll
in 1994, write:
After spending 25 years looking at particular allegations about
market inefficiencies, and 10 years attempting to exploit them as a
practicing money manager, I have become convinced that the
concept of efficient markets ought to be learned by every CFO.
Many of these effects are surprisingly strong in the reported
EFFICIENT MARKET HYPOTHESIS
P. 31
empirical work, but I have never found one that worked in
practice, in the sense that it returned more than a buy-and-hold
strategy. (p.100)
Taking empirical evidence in 1990’s all together, it seems fair to say the
notion of EMH is in a state of flux, and we are awaiting empirical studies in
the future to resolve the unsettling issue whether the capital market satisfies
informational efficiency/inefficiency.
In the following section, it can be
clearly seen, the heated debate has marched into the 21st century: On the one
hand, Malkiel (2003) makes a strong case for the continuation of the EMH.
On the other hand, Shiller (2003) urges forcefully the EMH be replaced by
behavioral finance paradigm.
VI. An Overall Assessment Including the On-going Debate of the EMH
Before we turn to an overall assessment, this is an appropriate
moment to discuss our way of evaluating empirical studies. This issue of
the joint hypothesis testing is, as pointed out earlier, well-recognized in
Jensen’s (1978) editorial note.
In other words, the empirical findings based on return-generating
EFFICIENT MARKET HYPOTHESIS
P. 32
models, especially the CAPM, fail to possess differentiating power because of
the nature of the joint-hypotheses testing: The capital market may indeed not
possess information efficiency as required by the notion of EMH; alternatively,
the capital market may still possess information efficiency as required by the
notion of EMH although the researchers in their research-setting misspecify
the CAPM.11
In a similar vein, it is ineligible for Fama (1991) to argue that the touchy
joint hypothesis testing problems disappears when even studies are conducted.
As Boldt & Arbit (1984) correctly point out, if the capital market satisfies
information efficiency as argued by the Fama, Jensen, Fisher and Roll (1969),
ambiguity remains.
Boldt & Arbit (1984) write:
Interestingly, FJFR’s evidence appears to indicate a gradual,
steady price response over the 30-month period prior to the split
announcement. Does this mean that investors were gradually
finding out about, and reacting to, information about a
forthcoming split?
“No,”said the authors.
…Even if we
accept their explanation at face value, however, the question still
EFFICIENT MARKET HYPOTHESIS
P. 33
arises: If the market were semi-strong efficient, why did it take a
few months for share prices to react to information about a
forthcoming split?
If the authors could detect abnormal residual,
why couldn’t investors have made the same discovery after only
the first month or two and reaped profits in the remainder?(p.26)
Viewed from such perspective, researchers still need to choose a
information-free pre-event base period so as they able to interpret the meaning
of the empirical findings.
In brief, this is the very reason that the author of
the present survey urges the researchers to choose truly nominal events in
testing EMH to avoid the quagmire of interpreting empirical findings. 11
It is also worth pointing out that, as noted earlier, the heated debate
clearly has marched into the 21st century. On the one hand, Malkiel (2003)
makes a strong case for the continuation of the EMH. On the other hand,
Shiller (2003) urges the EMH be replaced by behavioral finance paradigm.
On the one hand, Malkiel (2003) writes:
The preceding sections have pointed out many“anomalies”and
statistically significant predictable patterns in the stock returns
EFFICIENT MARKET HYPOTHESIS
P. 34
that have been uncovered in the literature. However, these
patterns are not robust and dependable in different sample periods,
and some of the patterns based on fundamental valuation
measures of individual stocks may simply reflect better proxies
for measuring risk. Moreover, many of these patterns, even if
they did exist, could self-destruct in the future, as many of them
have already done.”(p.71)
In contrast, Shiller (2003) writes:
Wishful thinking can dominate much of the work of a profession
for a decade, but not indefinitely. The 1970s already saw the
beginnings of some disquiet over these equilibrium asset price
models (emphasis added) and a tendency to push them somewhat
aside in favor of a more eclectic way of thinking about financial
markets and the economy. Browsing today again through
finance journals from the 1970s, one sees some beginnings of
reports of anomalies that didn’t seem likely to square with the
efficient markets theory, even if they were not presented as
EFFICIENT MARKET HYPOTHESIS
P. 35
significant evidence against the theory. (p.84)
…Indeed, we
have to distance ourselves from the presumption that financial
markets always work well and that price changes always reflect
genuine information.
…The challenge for economists is to make
this reality a better part of their models. (p.102)
On balance, it seems fair to echo the earlier statement that the notion of
EMH is in a state of flux, and we have to await further empirical studies
which can help differentiate these two opposing views.
It is hoped that readers at this stage have a fairly good understanding of
conceptual formulations, testing methods, and empirical findings associated
with the notion of EMH. Against such drop, the author will at this juncture
try his best to present a fair-handed assessment.
If we sit back for a moment,
we should realize that, as the author said at the outset, most scholars would
agree, albeit the capital market is flawed, it remains relatively speaking the
most efficient market in its capability of information processing. Despite the
mounting empirical evidence which runs against the EMH, the notion of EMH
is not one without merit. What we should guard against is that the EMH may
EFFICIENT MARKET HYPOTHESIS
P. 36
be transmogrified into a philosophic credence and lies beyond scientific
endeavor. After taking necessary reservations and exercising precautionary
interpretations, chances are, the EMH is here to stay and will continue to play
an important role in modern finance for years to come.
EFFICIENT MARKET HYPOTHESIS
P. 37
NOTES
1
What worries the challengers of the EMH is not that scholars who espouse
the notion of EMH have treated EMH as a pillar of modern finance, but that
they have elevated it to a God-like status.
According to Haugen (1999）, “On
April 16, 1998 at the UCLA Conference, “The Market Efficiency Debate: A
Break from Tradition,” while delivering a paper on market efficiency, Fama
pointed to me in the audience and called me a criminal.
He then said that he
believed that God knew that the stock market was efficient.
…” Note 5, at
the end of Chapter 7, The New Finance—The Case Against Efficient Markets,
p.71.
2
See related discussions on the joint hypothesis testing problem below.
3
Here, Keane (1986) is referring to D’Ambrosios’s (1984) editorial note.
4
The literature during this period has reported some other major anomalous
findings “capital market seasonality of stock returns” (Rozeff & Kinney
(1976)), “capital market seasonality of bond returns” (Schneeweis &
Woolridge (1979)), “the volatility of the stock prices cannot be justified by
subsequent changes in dividends” (Shiller (1981)), and, “the run structure for
EFFICIENT MARKET HYPOTHESIS
P. 38
large price change is different from the run structure for all price changes”
(Renshaw (1984)), and “the long-lasting January effect” (Haugen &
Lakonishok (1988)).
5
See D’Ambrosio (1984), “Editorial Viewpoint,” Financial Analysts Journal,
March/April 1984, p.58.
6
The interested readers are referred to the more detailed discussions of each
piece in the original editorial note.
7
In this category, it includes Galai (1978) because the author finds there is a
profit-making trading rule and Charest (1978b) because the author finds that
insensitive significant abnormal returns are brought about by the cash dividend
announcement.
8
We may include at this stage Robert J. Shiller among them. However, to
present his view in tandem with Malkiel (2003), I will delay the discussions of
his contributions until we come to an overall assessment on EMH.
In
addition, although no exact date was given, according to Shiller(2003),
“Richard Thaler and I started our National Bureau of Economic Research
conference series on behavioral finance in 1991, extending workshops that
EFFICIENT MARKET HYPOTHESIS
P. 39
Thaler had organized at the Russell Sage Foundation a few years earlier.”(p.91)
It was about that time the school of the behavioral finance came into existence.
9
The publishing year of the first edition was 1995.
For a fuller
understanding of the first edition of the book, the interested readers are
referred to Haugen (1995) and Haugen (1996).
10
This subsection draws heavily from Koonce’s (2001) book review on
Inefficient Markets: An Introduction to Behavioral Finance.
The interested
readers are referred to the original detailed review.
11
In view of the important role “model specification” plays in testing EMH, it
comes to us as no surprise that numerous studies have addressed to this issue.
See, for example, Brenner (1977,1979), Shiller (1981), McDonald & Nichols
(1984), Cochrane (1991), Zhou (1993), Schwaiger (1995), Malliaris & Stein
(1999).
12
A fundamental difficulty presents itself with regard to previous event studies
because in these studies the so-called nominal events such as stock
dividends/splits or dividends/earnings announcement have been used. The
difficulty under review is that a proponent of efficient capital markets always
EFFICIENT MARKET HYPOTHESIS
P. 40
stands to win.
When there are no associative price movements, he or she can
argue it is rightly so since stock markets in an efficient capital market should
be unresponsive to an event free of informational content. However, if price
movements do occur, he or she can still legitimately claim that the efficient
capital market hypothesis cannot thereby be rejected since the events chosen
are “seemingly” nominal rather than “truly” nominal. (pp.40-41)
In this
category, for instance, see, Lee, Yen, and Chang (1993) and Yen, Lee, Chen,
and Lin (2001), which examine the stock price movement in the neighborhood
of the Chinese Lunar New Year ―a truly nominal event― since both “real”
and “financial” transactions has been virtually suspended during such period
and find the movements in the stock price are inconsistent with the notion of
the EMH.
EFFICIENT MARKET HYPOTHESIS
P. 41
REFRENCES
[1]
Bachelier, Louis (1900), Theorie de la Speculation, Gauthiers-Villars,
Paris, Reprinted in English (A. J. Boness, trans.) in P. H. Cootner (ed.),
The Random Character of Stock Market Prices, MIT Press, Cambridge,
MA, 1964, pp.17-78.
[2]
Ball, Ray (1994), “The Development, Accomplishments and Limitations
of the Theory of Stock Market Efficiency,” Managerial Finance, 20,
pp.3-48.
[3]
Brealey, R. A., and Myer, S. C. (2000), Principles of Corporate
Finance,6th ed., Boston, MA: Irwin/McGraw-Hill.
[4]
Brenner, Menachem (1977), “The Effect of Model Misspecification on
Tests of the Efficient Market Hypothesis,” Journal of Finance, 32,
pp.57-66.
[5]
Brenner, Menachem (1979), “The Sensitivity of the Efficient Market
Hypothesis to Alternative Specifications of the Market Model,” Journal of
Finance, 34, pp.915-929.
[6]
Boldt, B. L., and Arbit H. L. (1984), “Efficient Markets and the
EFFICIENT MARKET HYPOTHESIS
P. 42
Professional Investor,” Financial Analysts Journal, 40, pp.22-34.
[7]
Cochrane, John H. (1991), “Volatility Tests and Efficient Markets: A
Review Essay,” Journal of Monetary Economics, 27, pp.463-465.
[8]
Conrad, Jennifer S. (1995), “The New Finance: The Case Against Efficient
Markets,” Journal of Finance, 50, pp.1348-1352.
[9]
Cothren, Richard (1982), “On the Impossibility of Informationally
Efficient Markets: Comment,” American Economic Review, 72,
pp.873-874.
[10]
D’Ambrosio, Charles A. (1984), “Editorial Viewpoint,” Financial Analysts
Journal, 40(2).
[11]
Fama, E. F., L. Fisher, M. C. Jensen, and R. Roll (1969) “The Adjustment
of Stock Price to New Information,” International Economic Review, 10,
pp.1-21.
[12]
Fama, Eugene F. (1965), “Random Walks in Stock Market Prices,”
Financial Analysts Journal, 21, pp.55-59.
[13]
Fama, Eugene F. (1970), “Efficient Capital Markets: A Review of Theory
and Empirical Work,” Journal of Finance, 25, pp.383-417.
EFFICIENT MARKET HYPOTHESIS
P. 43
[14]
Fama, Eugene F. (1991), “Efficient Capital Markets: II,” Journal of
Finance, 46, pp.1575-1617.
[15]
Fama, Eugene F. (1998), “Market Efficiency, Long-term Returns, and
Behavioral Finance,” Journal of Financial Economics, 49, pp.283-306.
[16]
Fridson, Martin S. (1994), “Advances in Behavioral Finance,” Financial
Analysts Journal, 50, pp.87-88.
[17]
Grossman, Sanford J., (1976), “On the Efficiency of Competitive
Stock-markets Where Trades Have Diverse Information,” Journal of
Finance, 31, pp.573-585.
[18]
Grossman, S. J., and J. E. Stiglitz (1980), “On the Impossibility of
Informationally Efficient Markets,” American Economic Review, 70,
pp.393-408.
[19]
Grossman, Sanford J. (1995), “Dynamic Asset Allocation and the
Informational Efficiency of Markets,” Journal of Finance, 50, pp.773-788.
[20]
Haugen R. A,. and J. Lakonishok (1988), The Incredible January Effect,
Homewood,: Illinois Dow Jones-Irwin.
[21]
Haugen, Robert A. (1995), The New Finance: The Case Against Efficient
EFFICIENT MARKET HYPOTHESIS
P. 44
Markets, 1st edition, Englewood Cliffs, NJ: Prentice Hall.
[22]
Haugen, Robert A. (1996), “Finance from a New Perspective,” Financial
Management, 25, pp.86-97.
[23]
Haugen, Robert A. (1999), The New Finance: The Case Against Efficient
Markets, 2nd edition, Upper Saddle River, NJ: Prentice Hall.
[24]
Jensen, Michael C. (1978), “Some Anomalous Evidence Regarding Market
Efficiency,” Journal of Financial Economics, 6, pp.95-101.
[25]
Keane, Simon M. (1986), “The Efficient Market Hypothesis on Trial,”
Financial Analysts Journal, 42, pp.58-63.
[26]
Kendall, Maurice G. (1953), “The Analysis of Economic Time Series, Part
I. Prices,” Journal of the Royal Statistical Society, 96, pp.11-25.
[27]
Koonce, Lisa (2001), “Inefficient Markets: An Introduction to Behavioral
Finance,” Accounting Review, 76, pp.461-462.
[28]
Kuhn, Thomas S. (1970), The Structure of Scientific Revolutions, 2nd ed.,
Chicago, Illinois: University of Chicago press.
[29]
Lee, C. F., G. Yen, and C. Chang (1993), “Informational Efficiency of
Capital Market Revisited: Anomalous Evidence from a Refined Test,”
EFFICIENT MARKET HYPOTHESIS
P. 45
Advances in Quantitative Finance and Accounting, 2, pp.39-65.
[30]
LeRoy, Stephen F. (1989), “Efficient Capital Markets and Martingales,”
Journal of Economic Literature, 27, pp.1583-1621.
[31]
Malkiel, Burton G. (2003), “The Efficient Market Hypothesis and its
Critics,” Journal of Economic Perspectives, 17, pp.59-82.
[32]
Malliaris, A. G., and J. L. Stein (1999), “Methodological Issues in Asset
Pricing: Random Walk or Chaotic Dynamics,” Journal of Banking and
Finance, 23, pp.1605-1635.
[33]
Mandelbrot, Benoit (1966), “Forecasts of Future Prices, Unbiased Markets,
and Martingale Models,” Journal of Business, 39 (Special Supplement),
pp.242-255.
[34]
McDonald, B., and W. D. Nichols (1984), “Nonstationarity of Beta and
Tests of Market Efficiency,” Journal of Financial Research, 7,
pp.315-322.
[35]
Nichols, Nancy A. (1993), “Efficient? Chaotic? What's the New Finance?”
Harvard Business Review, 71, pp.50-56.
[36]
Niederhoffer, V., and M. F. M. Osborne (1966), “Market Making and
EFFICIENT MARKET HYPOTHESIS
P. 46
Reversal on the Stock Exchange,” Journal of the American Statistical
Association, 61, pp.897-916.
[37]
Renshaw, Edward F. (1984), “Stock Market Panics: A Test of the Efficient
Market Hypothesis,” Financial Analysts Journal, 40, pp.48-51.
[38]
Rozeff, M. S., and W. R. Kinney., Jr. (1976), “Capital Market Seasonality:
The Case of Stock Returns,” Journal of Financial Economics, 3,
pp.379-402.
[39]
Samuelson, Paul A. (1965), “Proof that Properly Anticipated Prices
Fluctuate Randomly,” Industrial Management Review, 6, pp.41-49.
[40]
Schleifer, Andrei (2000), Inefficient Markets: An Introduction to
Behavioral Finance, Oxford, England: Oxford University Press.
[41]
Schneeweis, T., and J. R. Woolridge (1979), “Capital Market Seasonality:
The Case of Bond Returns,” Journal of Financial and Quantitative
Analysis, 14, pp.939-958
[42]
Scholes, Myron (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.
EFFICIENT MARKET HYPOTHESIS
P. 47
[43]
Schwaiger, Walter S. A.
(1995), “A Note on GARCH Predictable
Variances and Stock Market Efficiency,” Journal of Banking and Finance,
19, pp.949-953
[44]
Shanken, J., and C. W. Smith (1996), “Implications of Capital Markets
Research for Corporate Finance,” Financial Management, 25, pp.98-104.
[45]
Shiller, Robert J. (1981), “Do Stock Prices Move Too Much to be Justified
by Subsequent Changes in Dividends?” American Economic Review, 71,
pp.421-436.
[46]
Shiller, Robert J. (1981), “The Use of Volatility Measures in Assessing
Market Efficiency,” Journal of Finance, 36, pp.291-311.
[47]
Shiller, Robert J. (2003), “From Efficient Markets Theory to Behavioral
Finance,” Journal of Economic Perspectives, 17, pp.83-104
[48]
Thaler, Richard H. (1993), Advances in Behavioral Finance, New York,
NY: Russell Sage Foundation.
[49]
Yen, G., C. F. Lee, C. L. Chen, and W. C. Lin (2001), “On the Chinese
Lunar New Year Effect in Six Asian Stock Markets: An Empirical
Analysis,” Review of Pacific Basin Financial Markets and Policies, 4,
EFFICIENT MARKET HYPOTHESIS
P. 48
pp.463-478.
[50]
Zhou, Guofu (1993), “Asset-pricing Tests Under Alternative
Distributions,” Journal of Finance, 48, pp.1927-1942.