Market Rationality: Efficient Market Hypothesis versus Market Anomalies
By: Kadir Can Yalçın
The article by Yalçın (2010) deals with efficient market theory and market anomalies in order to
examine the question “Are markets rational or not”?
An efficient market can exist if there are a large number of rational profit-maximizing investors
who actively participate in the market and thus value securities rationally, if some investors are
not rational, their irrational trades cancel each other out or rational arbitrageurs eliminate their
influence without affecting prices, and if information is costless and widely available to market
participants. Investors respond swiftly and completely to new information, causing stock prices to
shift.
In terms of the availability of the three information sets indicated above, the efficient market
hypothesis is split into three stages: weak, semi-strong, and strong. Weak efficiency asserts that
current stock prices already represent all historical market data, such as previous prices and trade
volumes. Semi-strong efficiency states that, in addition to past prices, all publicly available
information, such as fundamental data on the firm's product line, earnings forecasts, dividends,
stock split announcements, management quality, balance sheet composition, patents held,
accounting practices, and so on, should be fully reflected in security prices. While strong form of
efficiency states that market prices reflect all information including both the past prices and the all
publicly available information, and plus all private information.
One of the assumptions of the efficient market hypothesis is that if both rational and irrational
investors are significantly associated with each other, some professional arbitragers would remove
their irrational behaviors and benefit. According to the efficient market theory, present security
prices are near to their intrinsic values as a result of either rational investors' or arbitragers'
purchase and sell action of under or overpriced equities. The uncertainty of noise traders' future
opinions is the explanation underlying the noise trader risk. Because of the potential of noise
traders continuing their crazy investment actions, an arbitrager will abandon or be terrified of an
arbitrage. That is, an arbitrager who purchases an underpriced security compared to its underlying
worth has not discounted the probability of the noisy trader pessimism persisting in the near future.
Otherwise, when they need to sell the securities to liquidate the investment, they would suffer an
unexpected loss.
Many observed market fluctuations are unaccounted for by the reasoning of the efficient market
hypothesis. Market fluctuations that contradict the efficient market hypothesis are referred to as
anomalies in mainstream finance theory. A variation from currently accepted paradigms that is too
broad to be disregarded, too systematic to be dismissed as random error, and too basic to be
handled by relaxing the normative framework is defined as an anomaly. Volume, volatility, cash
dividends, the equity premium puzzle, and predictability among the most often observed
anomalies.
Market rationality is the primary paradigm for organizing and directing markets. It is simple to
find an anomaly that contradicts the efficient market hypothesis; nevertheless, it is extremely
difficult to explain why they arise.