Efficient market hypothesis

Efficient market hypothesis

Overview
In finance
Finance
"Finance" is often defined simply as the management of money or “funds” management Modern finance, however, is a family of business activity that includes the origination, marketing, and management of cash and money surrogates through a variety of capital accounts, instruments, and markets created...

, the efficient-market hypothesis (EMH) asserts that financial markets are "informationally efficient". That is, one cannot consistently achieve returns in excess of average market returns on a risk-adjusted basis
Risk-weighted asset
Risk-weighted asset is a bank's assets or off-balance sheet exposures, weighted according to risk. This sort of asset calculation is used in determining the capital requirement or Capital Adequacy Ratio for a financial institution...

, given the information available at the time the investment is made.

There are three major versions of the hypothesis: "weak", "semi-strong", and "strong". The weak-form EMH claims that prices on traded assets (e.g., stocks
Stocks
Stocks are devices used in the medieval and colonial American times as a form of physical punishment involving public humiliation. The stocks partially immobilized its victims and they were often exposed in a public place such as the site of a market to the scorn of those who passed by...

, bonds
Bond (finance)
In finance, a bond is a debt security, in which the authorized issuer owes the holders a debt and, depending on the terms of the bond, is obliged to pay interest to use and/or to repay the principal at a later date, termed maturity...

, or property) already reflect all past publicly available information
Information
Information in its most restricted technical sense is a message or collection of messages that consists of an ordered sequence of symbols, or it is the meaning that can be interpreted from such a message or collection of messages. Information can be recorded or transmitted. It can be recorded as...

.
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In finance
Finance
"Finance" is often defined simply as the management of money or “funds” management Modern finance, however, is a family of business activity that includes the origination, marketing, and management of cash and money surrogates through a variety of capital accounts, instruments, and markets created...

, the efficient-market hypothesis (EMH) asserts that financial markets are "informationally efficient". That is, one cannot consistently achieve returns in excess of average market returns on a risk-adjusted basis
Risk-weighted asset
Risk-weighted asset is a bank's assets or off-balance sheet exposures, weighted according to risk. This sort of asset calculation is used in determining the capital requirement or Capital Adequacy Ratio for a financial institution...

, given the information available at the time the investment is made.

There are three major versions of the hypothesis: "weak", "semi-strong", and "strong". The weak-form EMH claims that prices on traded assets (e.g., stocks
Stocks
Stocks are devices used in the medieval and colonial American times as a form of physical punishment involving public humiliation. The stocks partially immobilized its victims and they were often exposed in a public place such as the site of a market to the scorn of those who passed by...

, bonds
Bond (finance)
In finance, a bond is a debt security, in which the authorized issuer owes the holders a debt and, depending on the terms of the bond, is obliged to pay interest to use and/or to repay the principal at a later date, termed maturity...

, or property) already reflect all past publicly available information
Information
Information in its most restricted technical sense is a message or collection of messages that consists of an ordered sequence of symbols, or it is the meaning that can be interpreted from such a message or collection of messages. Information can be recorded or transmitted. It can be recorded as...

. The semi-strong-form EMH claims both that prices reflect all publicly available information and that prices instantly change to reflect new public information. The strong-form EMH additionally claims that prices instantly reflect even hidden or "insider" information.
Critics have blamed the belief in rational markets
Rational expectations
Rational expectations is a hypothesis in economics which states that agents' predictions of the future value of economically relevant variables are not systematically wrong in that all errors are random. An alternative formulation is that rational expectations are model-consistent expectations, in...

 for much of the late-2000s financial crisis
Late-2000s financial crisis
The late-2000s financial crisis is considered by many economists to be the worst financial crisis since the Great Depression of the 1930s...

. In response, proponents of the hypothesis have stated that market efficiency does not mean having no uncertainty about the future, that market efficiency is a simplification of the world which may not always hold true, and that the market is practically efficient for investment purposes for most individuals.

Historical background


Historically, there was a very close link between EMH and the random-walk model
Random walk hypothesis
The random walk hypothesis is a financial theory stating that stock market prices evolve according to a random walk and thus the prices of the stock market cannot be predicted. It is consistent with the efficient-market hypothesis....

 and then the Martingale model. The random character of stock market prices was first modelled by Jules Regnault
Jules Regnault
Jules Augustin Frédéric Regnault was a French economist who first suggested a modern theory of stock price changes in Calcul des Chances et Philosophie de la Bourse and used a random walk model...

, a French broker, in 1863 and then by Louis Bachelier
Louis Bachelier
-External links:** Louis Bachelier webpage at the Université de Franche-Comté, Besançon / France. Text in French.** also from Index Funds Advisors, this discussion of...

, a French mathematician, in his 1900 PhD thesis, "The Theory of Speculation". His work was largely ignored until the 1950s; however beginning in the 30s scattered, independent work corroborated his thesis. A small number of studies indicated that US stock prices and related financial series followed a random walk model
Random walk hypothesis
The random walk hypothesis is a financial theory stating that stock market prices evolve according to a random walk and thus the prices of the stock market cannot be predicted. It is consistent with the efficient-market hypothesis....

. Research by Alfred Cowles
Alfred Cowles
Alfred Cowles, 3rd was an American economist, businessman and founder of the Cowles Commission. He graduated from Yale in 1913, where he was a member of Skull and Bones....

 in the ’30s and ’40s suggested that professional investors were in general unable to outperform the market.

The efficient-market hypothesis was developed by Professor Eugene Fama
Eugene Fama
Eugene Francis "Gene" Fama is an American economist, known for his work on portfolio theory and asset pricing, both theoretical and empirical. He is currently Robert R...

 at the University of Chicago Booth School of Business as an academic concept of study through his published Ph.D. thesis in the early 1960s at the same school. It was widely accepted up until the 1990s, when behavioral finance
Behavioral finance
Behavioral economics and its related area of study, behavioral finance, use social, cognitive and emotional factors in understanding the economic decisions of individuals and institutions performing economic functions, including consumers, borrowers and investors, and their effects on market...

 economists, who had been a fringe element, became mainstream. Empirical analyses have consistently found problems with the efficient-market hypothesis, the most consistent being that stocks with low price to earnings (and similarly, low price to cash-flow or book value) outperform other stocks. Alternative theories have proposed that cognitive bias
Cognitive bias
A cognitive bias is a pattern of deviation in judgment that occurs in particular situations. Implicit in the concept of a "pattern of deviation" is a standard of comparison; this may be the judgment of people outside those particular situations, or may be a set of independently verifiable...

es cause these inefficiencies, leading investors to purchase
overpriced growth stocks
Growth investing
Growth investing is a style of investment strategy. Those who follow this style, known as growth investors, invest in companies that exhibit signs of above-average growth, even if the share price appears expensive in terms of metrics such as price-to-earnings or price-to-book ratios...

 rather than value stocks
Value investing
Value investing is an investment paradigm that derives from the ideas on investment and speculation that Ben Graham and David Dodd began teaching at Columbia Business School in 1928 and subsequently developed in their 1934 text Security Analysis...

. Although the efficient-market hypothesis has become controversial because substantial and lasting inefficiencies are observed, Beechey et al. (2000) consider that it remains a worthwhile starting point.

The efficient-market hypothesis emerged as a prominent theory in the mid-1960s. Paul Samuelson
Paul Samuelson
Paul Anthony Samuelson was an American economist, and the first American to win the Nobel Memorial Prize in Economic Sciences. The Swedish Royal Academies stated, when awarding the prize, that he "has done more than any other contemporary economist to raise the level of scientific analysis in...

 had begun to circulate Bachelier's work among economists. In 1964 Bachelier's dissertation along with the empirical studies mentioned above were published in an anthology edited by Paul Cootner. In 1965 Eugene Fama published his dissertation arguing for the random walk hypothesis, and Samuelson published a proof for a version of the efficient-market hypothesis. In 1970 Fama published a review of both the theory and the evidence for the hypothesis. The paper extended and refined the theory, included the definitions for three forms of financial market efficiency
Financial market efficiency
In the 1970s Eugene Fama defined an efficient financial market as "one in which prices always fully reflect available information”.The most common type of efficiency referred to in financial markets is the allocative efficiency, or the efficiency of allocating resources.This includes producing the...

: weak, semi-strong and strong (see below).

It has been argued that the stock market is “micro efficient” but “macro inefficient”. The main proponent of this view was Samuelson, who asserted that the EMH is much better suited for individual stocks than it is for the aggregate stock market. Research based on regression and scatter diagrams has strongly supported Samuelson's dictum.

Further to this evidence that the UK stock market is weak-form efficient, other studies of capital markets have pointed toward their being semi-strong-form efficient. A study by Khan of the grain futures market indicated semi-strong form efficiency following the release of large trader position information (Khan, 1986). Studies by Firth (1976, 1979, and 1980) in the United Kingdom have compared the share prices existing after a takeover announcement with the bid offer. Firth found that the share prices were fully and instantaneously adjusted to their correct levels, thus concluding that the UK stock market was semi-strong-form efficient. However, the market's ability to efficiently respond to a short term, widely publicized event such as a takeover announcement does not necessarily prove market efficiency related to other more long term, amorphous factors. David Dreman has criticized the evidence provided by this instant "efficient" response, pointing out that an immediate response is not necessarily efficient, and that the long-term performance of the stock in response to certain movements are better indications. A study on stocks' response to dividend cuts or increases over three years found that after an announcement of a dividend cut, stocks underperformed the market by 15.3% for the three-year period, while stocks outperformed the market by 24.8% for the three years following the announcement of a dividend increase.

Theoretical background


Beyond the normal utility
Utility
In economics, utility is a measure of customer satisfaction, referring to the total satisfaction received by a consumer from consuming a good or service....

 maximizing agents, the efficient-market hypothesis requires that agents have rational expectations
Rational expectations
Rational expectations is a hypothesis in economics which states that agents' predictions of the future value of economically relevant variables are not systematically wrong in that all errors are random. An alternative formulation is that rational expectations are model-consistent expectations, in...

; that on average the population is correct (even if no one person is) and whenever new relevant information appears, the agents update their expectations appropriately. Note that it is not required that the agents be rational. EMH allows that when faced with new information, some investors may overreact and some may underreact. All that is required by the EMH is that investors' reactions be random and follow a normal distribution pattern so that the net effect on market prices cannot be reliably exploited to make an abnormal profit, especially when considering transaction costs (including commissions and spreads). Thus, any one person can be wrong about the market—indeed, everyone can be—but the market as a whole is always right. There are three common forms in which the efficient-market hypothesis is commonly stated—weak-form efficiency,
semi-strong-form efficiency and strong-form efficiency, each of which has different implications for how markets work.

In weak-form efficiency, future prices cannot be predicted by analyzing prices from the past. Excess returns cannot be earned in the long run by using investment strategies based on historical share prices or other historical data. Technical analysis
Technical analysis
In finance, technical analysis is security analysis discipline for forecasting the direction of prices through the study of past market data, primarily price and volume. Behavioral economics and quantitative analysis incorporate technical analysis, which being an aspect of active management stands...

 techniques will not be able to consistently produce excess returns, though some forms of fundamental analysis
Fundamental analysis
Fundamental analysis of a business involves analyzing its financial statements and health, its management and competitive advantages, and its competitors and markets. When applied to futures and forex, it focuses on the overall state of the economy, interest rates, production, earnings, and...

 may still provide excess returns. Share prices exhibit no serial dependencies, meaning that there are no "patterns" to asset prices. This implies that future price movements are determined entirely by information not contained in the price series. Hence, prices must follow a random walk. This 'soft' EMH does not require that prices remain at or near equilibrium, but only that market participants not be able to systematically profit from market 'inefficiencies
Market anomaly
A market anomaly is a price and/or return distortion on a financial market that seems to contradict the efficient market hypothesis.The market anomaly usually relates to:...

'. However, while EMH predicts that all price movement (in the absence of change in fundamental information) is random (i.e., non-trending), many studies have shown a marked tendency for the stock markets to trend over time periods of weeks or longer and that, moreover, there is a positive correlation between degree of trending and length of time period
studied (but note that over long time periods, the trending is sinusoidal in appearance). Various explanations for such large and apparently non-random price movements have been promulgated.

The problem of algorithmically constructing prices which reflect all available information has been studied extensively in the field of computer science. For example, the complexity of finding the arbitrage opportunities in pair betting markets has been shown to be NP-hard
NP-hard
NP-hard , in computational complexity theory, is a class of problems that are, informally, "at least as hard as the hardest problems in NP". A problem H is NP-hard if and only if there is an NP-complete problem L that is polynomial time Turing-reducible to H...

.

In semi-strong-form efficiency, it is implied that share prices adjust to publicly available new information very rapidly and in an unbiased fashion, such that no excess returns can be earned by trading on that information. Semi-strong-form efficiency implies that neither fundamental analysis
Fundamental analysis
Fundamental analysis of a business involves analyzing its financial statements and health, its management and competitive advantages, and its competitors and markets. When applied to futures and forex, it focuses on the overall state of the economy, interest rates, production, earnings, and...

 nor technical analysis
Technical analysis
In finance, technical analysis is security analysis discipline for forecasting the direction of prices through the study of past market data, primarily price and volume. Behavioral economics and quantitative analysis incorporate technical analysis, which being an aspect of active management stands...

 techniques will be able to reliably produce excess returns. To test for semi-strong-form efficiency, the adjustments to previously unknown news must be of a reasonable size and must be instantaneous. To test for this, consistent upward or downward adjustments after the initial change must be looked for. If there are any such adjustments it would suggest that investors had interpreted the information in a biased fashion and hence in an inefficient manner.

In strong-form efficiency, share prices reflect all information, public and private, and no one can earn excess returns. If there are legal barriers to private information becoming public, as with insider trading laws, strong-form efficiency is impossible, except in the case where the laws are universally ignored. To test for strong-form efficiency, a market needs to exist where investors cannot consistently earn excess returns over a long period of time. Even if some money managers are consistently observed to beat the market, no refutation even of strong-form efficiency follows: with hundreds of thousands of fund managers worldwide, even a normal distribution of returns (as efficiency predicts) should be expected to produce a few dozen "star" performers.

Criticism and behavioral finance



Investors and researchers have disputed the efficient-market hypothesis both empirically and theoretically. Behavioral economists
Behavioral finance
Behavioral economics and its related area of study, behavioral finance, use social, cognitive and emotional factors in understanding the economic decisions of individuals and institutions performing economic functions, including consumers, borrowers and investors, and their effects on market...

 attribute the imperfections in financial markets to a combination of cognitive bias
Cognitive bias
A cognitive bias is a pattern of deviation in judgment that occurs in particular situations. Implicit in the concept of a "pattern of deviation" is a standard of comparison; this may be the judgment of people outside those particular situations, or may be a set of independently verifiable...

es such as overconfidence, overreaction, representative bias, information bias
Information bias
Information bias is a type of cognitive bias, and involves e.g. distorted evaluation of information. Information bias occurs due to people's curiosity and confusion of goals when trying to choose a course of action.-Over-evaluation of information:...

, and various other predictable human errors in reasoning and information processing. These have been researched by psychologists such as Daniel Kahneman
Daniel Kahneman
Daniel Kahneman is an Israeli-American psychologist and Nobel laureate. He is notable for his work on the psychology of judgment and decision-making, behavioral economics and hedonic psychology....

, Amos Tversky
Amos Tversky
Amos Nathan Tversky, was a cognitive and mathematical psychologist, a pioneer of cognitive science, a longtime collaborator of Daniel Kahneman, and a key figure in the discovery of systematic human cognitive bias and handling of risk. Much of his early work concerned the foundations of measurement...

, Richard Thaler
Richard Thaler
Richard H. Thaler is an American economist and the Ralph and Dorothy Keller Distinguished Service Professor of Behavioral Science and Economics at the University of Chicago Booth School of Business...

, and Paul Slovic
Paul Slovic
Paul Slovic is a professor of psychology at the University of Oregon and the president of the Decision Research group. He earned his Ph.D. in psychology at the University of Michigan in 1964....

. These errors in reasoning lead most investors to avoid value stocks and buy growth stock
Growth stock
In finance, a growth stock is a stockof a company that generates substantial and sustainable positive cash flow and whose revenues and earnings are expected to increase at a faster rate than the average company within the same industry...

s at expensive prices, which allow those who reason correctly to profit from bargains in neglected value stocks and the overreacted selling of growth stocks.

Empirical evidence has been mixed, but has generally not supported strong forms of the efficient-market hypothesis According to Dreman and Berry, in a 1995 paper, low P/E stocks have greater returns. In an earlier paper Dreman also refuted the assertion by Ray Ball that these higher returns could be attributed to higher beta, whose research had been accepted by efficient market theorists as explaining the anomaly in neat accordance with modern portfolio theory
Modern portfolio theory
Modern portfolio theory is a theory of investment which attempts to maximize portfolio expected return for a given amount of portfolio risk, or equivalently minimize risk for a given level of expected return, by carefully choosing the proportions of various assets...

.

One can identify "losers" as stocks that have had poor returns over some number of past years. "Winners" would be those stocks that had high returns over a similar period. The main result of one such study is that losers have much higher average returns than winners over the following period of the same number of years. A later study showed that beta (β) cannot account for this difference in average returns. This tendency of returns to reverse over long horizons (i.e., losers become winners) is yet another contradiction of EMH. Losers would have to
have much higher betas than
winners in order to justify the return difference. The study showed that the beta difference required to save the EMH is just not there.

Speculative economic bubble
Economic bubble
An economic bubble is "trade in high volumes at prices that are considerably at variance with intrinsic values"...

s are an obvious anomaly, in that the market often appears to be driven by buyers operating on irrational exuberance, who take little notice of underlying value. These bubbles are typically followed by an overreaction of frantic selling, allowing shrewd investors to buy stocks at bargain prices. Rational investors have difficulty profiting by shorting irrational bubbles because, as John Maynard Keynes
John Maynard Keynes
John Maynard Keynes, Baron Keynes of Tilton, CB FBA , was a British economist whose ideas have profoundly affected the theory and practice of modern macroeconomics, as well as the economic policies of governments...

 commented, "Markets can remain irrational far longer than you or I can remain solvent." Sudden market crashes as happened on Black Monday in 1987
Black Monday (1987)
In finance, Black Monday refers to Monday October 19, 1987, when stock markets around the world crashed, shedding a huge value in a very short time. The crash began in Hong Kong and spread west to Europe, hitting the United States after other markets had already declined by a significant margin...

 are mysterious from the perspective of efficient markets, but allowed as a rare statistical event under the Weak-form of EMH.

Burton Malkiel
Burton Malkiel
Burton Gordon Malkiel is an American economist and writer, most famous for his classic finance book A Random Walk Down Wall Street...

, a well-known proponent of the general validity of EMH, has warned that certain emerging markets such as China
China
Chinese civilization may refer to:* China for more general discussion of the country.* Chinese culture* Greater China, the transnational community of ethnic Chinese.* History of China* Sinosphere, the area historically affected by Chinese culture...

 are not empirically efficient; that the Shanghai
Shanghai Stock Exchange
The Shanghai Stock Exchange , abbreviated as 上证所/上證所 or 上交所, is a stock exchange that is based in the city of Shanghai, China. It is one of the two stock exchanges operating independently in the People's Republic of China, the other is the Shenzhen Stock Exchange...

 and Shenzhen
Shenzhen Stock Exchange
The Shenzhen Stock Exchange is one of the People's Republic of China's two stock exchanges, alongside the Shanghai Stock Exchange. It is based in Shenzhen, China...

 markets, unlike markets in United States, exhibit considerable serial correlation (price trends
Market trends
A market trend is a putative tendency of a financial market to move in a particular direction over time. These trends are classified as secular for long time frames, primary for medium time frames, and secondary for short time frames...

), non-random walk, and evidence of manipulation.

Behavioral psychology approaches to stock market trading are among some of the more promising alternatives to EMH (and some investment strategies seek to exploit exactly such inefficiencies). But Nobel Laureate co-founder of the programme—Daniel Kahneman
Daniel Kahneman
Daniel Kahneman is an Israeli-American psychologist and Nobel laureate. He is notable for his work on the psychology of judgment and decision-making, behavioral economics and hedonic psychology....

—announced his skepticism of investors beating the market: "They're [investors] just not going to do it [beat the market]. It's just not going to happen." Indeed defenders of EMH maintain that Behavioral Finance strengthens the case for EMH in that BF highlights biases in individuals and committees and not competitive markets. For example, one prominent finding in Behaviorial Finance is that individuals employ hyperbolic discounting
Hyperbolic discounting
In behavioral economics, hyperbolic discounting is a time-inconsistent model of discounting.Given two similar rewards, humans show a preference for one that arrives sooner rather than later. Humans are said to discount the value of the later reward, by a factor that increases with the length of the...

. It is palpably true that bonds
Bond (finance)
In finance, a bond is a debt security, in which the authorized issuer owes the holders a debt and, depending on the terms of the bond, is obliged to pay interest to use and/or to repay the principal at a later date, termed maturity...

, mortgages, annuities
Annuity (finance theory)
The term annuity is used in finance theory to refer to any terminating stream of fixed payments over a specified period of time. This usage is most commonly seen in discussions of finance, usually in connection with the valuation of the stream of payments, taking into account time value of money...

 and other similar financial instruments
Financial instruments
A financial instrument is a tradable asset of any kind, either cash; evidence of an ownership interest in an entity; or a contractual right to receive, or deliver, cash or another financial instrument....

 subject to competitive market forces do not
Bond valuation
Bond valuation is the determination of the fair price of a bond. As with any security or capital investment, the theoretical fair value of a bond is the present value of the stream of cash flows it is expected to generate. Hence, the value of a bond is obtained by discounting the bond's expected...

. Any manifestation of hyperbolic discounting
Hyperbolic discounting
In behavioral economics, hyperbolic discounting is a time-inconsistent model of discounting.Given two similar rewards, humans show a preference for one that arrives sooner rather than later. Humans are said to discount the value of the later reward, by a factor that increases with the length of the...

 in the pricing of these obligations would invite arbitrage
Arbitrage
In economics and finance, arbitrage is the practice of taking advantage of a price difference between two or more markets: striking a combination of matching deals that capitalize upon the imbalance, the profit being the difference between the market prices...

 thereby quickly eliminating any vestige of individual biases. Similarly, diversification
Diversification (finance)
In finance, diversification means reducing risk by investing in a variety of assets. If the asset values do not move up and down in perfect synchrony, a diversified portfolio will have less risk than the weighted average risk of its constituent assets, and often less risk than the least risky of...

, derivative securities
Derivative (finance)
A derivative instrument is a contract between two parties that specifies conditions—in particular, dates and the resulting values of the underlying variables—under which payments, or payoffs, are to be made between the parties.Under U.S...

 and other hedging strategies assuage if not eliminate potential mispricings from the severe risk-intolerance (loss aversion
Loss aversion
In economics and decision theory, loss aversion refers to people's tendency to strongly prefer avoiding losses to acquiring gains. Some studies suggest that losses are twice as powerful, psychologically, as gains....

) of individuals underscored by behavioral finance. On the other hand, economists, behaviorial psychologists and mutual fund managers are drawn from the human population and are therefore subject to the biases that behavioralists showcase. By contrast, the price signals in markets are far less subject to individual biases highlighted by the Behavioral Finance programme. Richard Thaler
Richard Thaler
Richard H. Thaler is an American economist and the Ralph and Dorothy Keller Distinguished Service Professor of Behavioral Science and Economics at the University of Chicago Booth School of Business...

 has started a fund based on his research on cognitive biases. In a 2008 report he identified complexity
Complexity
In general usage, complexity tends to be used to characterize something with many parts in intricate arrangement. The study of these complex linkages is the main goal of complex systems theory. In science there are at this time a number of approaches to characterizing complexity, many of which are...

 and herd behavior
Herd behavior
Herd behavior describes how individuals in a group can act together without planned direction. The term pertains to the behavior of animals in herds, flocks and schools, and to human conduct during activities such as stock market bubbles and crashes, street demonstrations, sporting events,...

 as central to the global financial crisis of 2008.

Further empirical work has highlighted the impact transaction costs have on the concept of market efficiency, with much evidence suggesting that any anomalies pertaining to market inefficiencies are the result of a cost benefit analysis made by those willing to incur the cost of acquiring the valuable information in order to trade on it. Additionally the concept of liquidity is a critical component to capturing "inefficiencies" in tests for abnormal returns. Any test of this proposition faces the joint hypothesis problem, where it is impossible to ever test for market efficiency, since to do so requires the use of a measuring stick against which abnormal returns are compared - one cannot know if the market is efficient if one does not know if a model correctly stipulates the required rate of return. Consequently, a situation arises where either the asset pricing model is incorrect or the market is inefficient, but one has no way of knowing which is the case.

A key work on random walk was done in the late 1980s by Profs. Andrew Lo and Craig MacKinlay; they effectively argue that a random walk does not exist, nor ever has. Their paper took almost two years to be accepted by academia and in 1999 they published "A Non-random Walk Down Wall St." which collects their research papers on the topic up to that time.

Economists Matthew Bishop and Michael Green claim that full acceptance of the hypothesis goes against the thinking of Adam Smith
Adam Smith
Adam Smith was a Scottish social philosopher and a pioneer of political economy. One of the key figures of the Scottish Enlightenment, Smith is the author of The Theory of Moral Sentiments and An Inquiry into the Nature and Causes of the Wealth of Nations...

 and John Maynard Keynes
John Maynard Keynes
John Maynard Keynes, Baron Keynes of Tilton, CB FBA , was a British economist whose ideas have profoundly affected the theory and practice of modern macroeconomics, as well as the economic policies of governments...

, who both believed irrational behavior had a real impact on the markets.

Warren Buffett
Warren Buffett
Warren Edward Buffett is an American business magnate, investor, and philanthropist. He is widely regarded as one of the most successful investors in the world. Often introduced as "legendary investor, Warren Buffett", he is the primary shareholder, chairman and CEO of Berkshire Hathaway. He is...

 has also argued against EMH, saying the preponderance of value investors among the world's best money managers rebuts the claim of EMH proponents that luck is the reason some investors appear more successful than others.

Late 2000s financial crisis


The financial crisis of 2007–2010 has led to renewed scrutiny and criticism of the hypothesis. Market strategist Jeremy Grantham
Jeremy Grantham
Jeremy Grantham is a British investor and Co-founder and Chief Investment Strategist of Grantham Mayo Van Otterloo , a Boston-based asset management firm. GMO is one of the largest managers of such funds in the world, having more than US $107 billion in assets under management as of December 2010...

 has stated flatly that the EMH is responsible for the current financial crisis, claiming that belief in the hypothesis caused financial leaders to have a "chronic underestimation of the dangers of asset bubbles breaking". Noted financial journalist Roger Lowenstein
Roger Lowenstein
Roger Lowenstein is an American financial journalist and writer. He graduated from Cornell University and reported for the Wall Street Journal for more than a decade, including two years writing its Heard on the Street column, 1989 to 1991. Born in 1955, he is the son of Helen and Louis Lowenstein...

 blasted the theory, declaring "The upside of the current Great Recession is that it could drive a stake through the heart of the academic nostrum known as the efficient-market hypothesis." Former Federal Reserve chairman Paul Volcker
Paul Volcker
Paul Adolph Volcker, Jr. is an American economist. He was the Chairman of the Federal Reserve under United States Presidents Jimmy Carter and Ronald Reagan from August 1979 to August 1987. He is widely credited with ending the high levels of inflation seen in the United States in the 1970s and...

 chimed in, saying it's "clear that among the causes of the recent financial crisis was an unjustified faith in rational expectations [and] market efficiencies."

At the International Organization of Securities Commissions annual conference, held in June 2009, the hypothesis took center stage. Martin Wolf
Martin Wolf
Martin Wolf, CBE is a British journalist, widely considered to be one of the world's most influential writers on economics. He is associate editor and chief economics commentator at the Financial Times.-Early life:...

, the chief economics commentator for the Financial Times
Financial Times
The Financial Times is an international business newspaper. It is a morning daily newspaper published in London and printed in 24 cities around the world. Its primary rival is the Wall Street Journal, published in New York City....

, dismissed the hypothesis as being a useless way to examine how markets function in reality. Paul McCulley
Paul McCulley
Paul Allen McCulley is a former managing director at PIMCO. He coined the terms Minsky moment and Shadow banking system which became famous during the Financial crisis of 2007-2009....

, managing director of PIMCO, was less extreme in his criticism, saying that the hypothesis had not failed, but was "seriously flawed" in its neglect of human nature.

The financial crisis has led Richard Posner
Richard Posner
Richard Allen Posner is an American jurist, legal theorist, and economist who is currently a judge on the United States Court of Appeals for the Seventh Circuit in Chicago and a Senior Lecturer at the University of Chicago Law School...

, a prominent judge, University of Chicago law professor, and innovator in the field of Law and Economics, to back away from the hypothesis and express some degree of belief in Keynesian economics
Keynesian economics
Keynesian economics is a school of macroeconomic thought based on the ideas of 20th-century English economist John Maynard Keynes.Keynesian economics argues that private sector decisions sometimes lead to inefficient macroeconomic outcomes and, therefore, advocates active policy responses by the...

. Posner accused some of his Chicago School colleagues of being "asleep at the switch", saying that "the movement to deregulate the financial industry went too far by exaggerating the resilience - the self healing powers - of laissez-faire capitalism." Others, such as Fama
Eugene Fama
Eugene Francis "Gene" Fama is an American economist, known for his work on portfolio theory and asset pricing, both theoretical and empirical. He is currently Robert R...

 himself, said that the hypothesis held up well during the crisis and that the markets were a casualty of the recession, not the cause of it. Despite this, Fama has conceded that "poorly informed investors could theoretically lead the market astray" and that stock prices could become "somewhat irrational" as a result.

Critics have suggested that financial institutions and corporations have been able to reduce the efficiency of financial markets by creating private information and reducing the accuracy of conventional disclosures, and by developing new and complex products which are challenging for most market participants to evaluate and correctly price.

See also


  • Adaptive market hypothesis
    Adaptive market hypothesis
    The adaptive market hypothesis, as proposed by Andrew Lo, is an attempt to reconcile economic theories based on the efficient market hypothesis with behavioral economics, by applying the principles of evolution to financial interactions: competition, adaptation and natural selection.Under this...

  • Arbitrage
    Arbitrage
    In economics and finance, arbitrage is the practice of taking advantage of a price difference between two or more markets: striking a combination of matching deals that capitalize upon the imbalance, the profit being the difference between the market prices...

  • Financial market efficiency
    Financial market efficiency
    In the 1970s Eugene Fama defined an efficient financial market as "one in which prices always fully reflect available information”.The most common type of efficiency referred to in financial markets is the allocative efficiency, or the efficiency of allocating resources.This includes producing the...

  • Eugene Fama
    Eugene Fama
    Eugene Francis "Gene" Fama is an American economist, known for his work on portfolio theory and asset pricing, both theoretical and empirical. He is currently Robert R...

  • Finance
    Finance
    "Finance" is often defined simply as the management of money or “funds” management Modern finance, however, is a family of business activity that includes the origination, marketing, and management of cash and money surrogates through a variety of capital accounts, instruments, and markets created...

  • Insider trading
    Insider trading
    Insider trading is the trading of a corporation's stock or other securities by individuals with potential access to non-public information about the company...

  • Investment theory
    Investment theory
    Investment theory encompasses the body of knowledge used to support the decision-making process of choosing investments for various purposes. It includes portfolio theory, the Capital Asset Pricing Model, Arbitrage Pricing Theory, and the Efficient market hypothesis.-References:*...

  • Market anomaly
    Market anomaly
    A market anomaly is a price and/or return distortion on a financial market that seems to contradict the efficient market hypothesis.The market anomaly usually relates to:...

  • Microeconomics
    Microeconomics
    Microeconomics is a branch of economics that studies the behavior of how the individual modern household and firms make decisions to allocate limited resources. Typically, it applies to markets where goods or services are being bought and sold...

  • Paul Samuelson
    Paul Samuelson
    Paul Anthony Samuelson was an American economist, and the first American to win the Nobel Memorial Prize in Economic Sciences. The Swedish Royal Academies stated, when awarding the prize, that he "has done more than any other contemporary economist to raise the level of scientific analysis in...

  • Technical analysis
    Technical analysis
    In finance, technical analysis is security analysis discipline for forecasting the direction of prices through the study of past market data, primarily price and volume. Behavioral economics and quantitative analysis incorporate technical analysis, which being an aspect of active management stands...

  • Transparency (market)
    Transparency (market)
    In economics, a market is transparent if much is known by many about:* What products, services or capital assets are available.* What price.* Where....

  • Noisy market hypothesis
    Noisy market hypothesis
    In finance, the noisy market hypothesis contrasts the efficient-market hypothesis in that it claims that the prices of securities are not always the best estimate of the true underlying value of the firm...

  • Dumb agent theory
    Dumb agent theory
    The dumb agent theory states that many people making individual buying and selling decisions will better reflect true value than any one individual can. In finance this theory is predicated on the efficient-market hypothesis . One of the first instances of the dumb agent theory in action was with...



External links