Validity of Efficient Market Hypothesis - Coursework Example

VALIDITY OF EFFICIENT MARKET HYPOTHESIS Prepared by (Student’s Name) Professor’s Name Course Name University Name Date Efficient market hypothesis relates to the notion that a given market relies on an already set out information trend in order to allow for the determination of security prices. In essence, the market is deemed to be efficient in regards to whether security prices will be unaffected even after presenting that information to all participants (Abergel &Politi, 2013). For the few decades or so, the efficient market hypothesis has been accepted within the overall academic financial economists. The concept has been associated with securities markets where it was believed that it was effectively efficient in portraying detailed information related to individual sticks as well as the stock market (Westerlund & Narayan, 2013). The assumption related to this perception ascertained that whenever there was information on stocks; related news would spread much more quickly and would be integrated into the different prices of the securities without any degree of delay. Following this line of reasoning, it is clear that neither technical analysis that is involved with the study of past stock prices in an effort to predict future prices or nor fundamental analysis, which is involved with the evaluation of financial information like entity’s earnings, asset values to assist existing investors in the selection of undervalued individual stocks; would facilitate them to accomplish a greater level of returns in comparison to information that could be accessed by opting to hold a randomly selected portfolio of individual stocks with a comparable level of risk (Malhotra, Tandon, & Tandon, 2015). Thus, the purpose of this paper is to critically examine the validity of a stronger efficient market hypothesis in relation to current literature. The concept of efficient market hypothesis can be compared with the notion of a random walk; which is basically a term that is loosely adopted within the financial literature in order to characterise a price pattern that allow consequent price alterations depict random shift from previous prices (Westerlund, Norkute, & Narayan, 2015). The logic behind the random walk analogy lies in the fact that the overall flow of information is indeed unimpeded and that it is immediately portrayed within the individual stock prices since as the next day’s price changes it will only be portrayed in that day’s news and will not be related in any way with the different alterations in prices today (Sheikh & Noreen, 2012). But off course, news is usually unpredictable in nature hence resulting price alterations should always be unpredictable and random at all times. In consequence, prices should fully portray all known form of known detailed accounting information so that also those uninformed investors purchasing onto a diversified portfolio at a series of certain price trends ascertained by the market should also be able to obtain a given rate of return that is deemed to be fair and similar to one accomplished with the experts. In effect, at the start of 21st century, the overall dominance of the concept began to deteriorate in regards to its universal applicability (Sheikh & Noreen, 2012). Most of the financial economists were of the opinion that the underlying stock prices can be partially predictable in a way. These experts indicated that there was need for emphasising the psychological and behavioural concepts of stock prices evaluation and establishment. They further postulated that the future stock prices are somehow predictable on the focus of the past stock price trends in relation to certain fundamental valuation metrics. Zafar, Chaubey, and Bhatt (2013, p.186) notes that even though it is imminently possible to have doubt on the statistical capacity of most of the aforementioned predictable trends emphasised by these financial economists; the whole idea can be sceptical. For instance, in the event that market prices would often fail to portray distinctive approximations of the prospects of entities; and when they would consistently operate on either over or under-reactions to specific set conditions, then it is will be possible that the expert investors that are enormously informed to outdo the partial counterparts and able to generate excess returns. However, this is not always the case since the market is always efficient and thus, these investors fail to outperform the overall market operations (Zafar, Chaubey, & Bhatt, 2013). In fact, most of the literature reviews conducted in the recent period ascertains that the markets are tremendously efficient at adjusting in a more effective way to all new detailed information. Following this line of reasoning, it is advisable that both individual and institutional-based equity investors should make efforts to develop their portfolios with a low-cost wide-based index fund that is able to withhold all of the stocks offered in the securities market. In the event that prices are deemed to be irrational and in cases where market returns are predictable as some of the concept critics ascertain, then for this case it is more than likely that actively managed investment funds should at all time be able to outperform passive index funds that are only focused on purchasing and holding market portfolios (Abergel &Politi, 2013). The figure below shows that all actively managed mutual funds do not necessarily outperform comparable benchmark indexes in the long run. In this next section, the paper focuses on coming up with different studies that have ensured to portray the possible predictability in regards to the behaviour of past stock pricing mechanisms. The short-term momentum that include an under-reaction to new information is an empirical study that supported the perception that the overall stock market does not necessarily have any form of memory; meaning that the manner for which a stock price behaved in previous periods not necessarily provide a basis for determining its behaviour in the future periods (Abergel &Politi, 2013). For example, researches conducted to ascertain this fact indicated that the short-run serial correlations could not attain a zero figure and that the presence of enormous successive shifts within a similar direction would facilitate them to overlook the hypothesis that stock prices would normally behave as random walks (Abergel &Politi, 2013). It is also discovered that some of the stock-price signals that are adopted by technical analysts like “head and shoulders” formation as well as “double bottoms” could actually result to predictive power. It is important to note that most of the financial economists and psychologists today working within the behavioural finance field postulate that short-run momentum were somehow in line with the underlying psychological mechanisms. For this case, analysts are deemed to easily perceive a certain stock price improving and, as a result attracted to the market in a manner postulating the bandwagon effect. For instance, the rise in the United States of America stock prices in the course of the late 1990s was highly attributed to the psychological phenomenon that resulted to irrational enthusiasm (Jain, 2012). Short-run momentum was also expounded in relation to the tendency of existing investors to under-react to new detailed information. In the event that the impact of crucial news announcements is hold onto for certain period of time; it was expected that the stock prices would postulate a positive serial correlation that are noted by investigators. The long-run return reversal is yet another fundamental study meant to expound on the behaviour of stock prices. In the short-run when returns are determined over a given number of days or weeks; the underlying argument related to market efficiency ascertains that positive correlations must exist (Jain, 2012). However, in the recent studies, researchers have been able to show overwhelming evidence related to negative serial correlations- which are return reversals over long holding periods. This forecastability is attributed to the underlying tendency of stock market prices to overreact. For example, it is argued that since investors operate on optimism and pessimism waves; they experience price variations in order to deviate in a systematic manner from their overall fundamental values while exhibiting mean reversions (Campanella, Mustilli, & D’Angelo, 2016). As such, it is indeed certain to postulate that there is immense support for long run negative serial correlations in aspects related to stock returns. Research suggests that both transactions costs and trading barriers later the tests of market efficiency in more than one single way (Campanella, Mustilli, & D’Angelo, 2016). It is argued that whenever the transactions costs are deemed to be high, the aspect of forecastability is no longer provided by arbitrage given that it would be a bit costly to take advantage of an enormous, predictable component in possible returns. For instance, an existing investor might forecast that certain stocks will outdo the securities market by let’s say 2% in the coming year; however; in the event that the transaction cost from purchasing the securities is in excess of 3% then the entire asset prediction might not be profitable at all(Abergel &Politi, 2013). Following this line of reasoning, the aspect of predictability thus has to be perceived in regards to the underlying transaction costs of the securities at hand. Notably, forecastability trends are only concerned with the invalidation of the efficient market hypothesis in the event that they are deemed to be extensive enough to offset the underlying size of the transactions costs. Of particular interest to note, in the event that the activity involved with short-selling is deemed to be a challenge, it is recommended that specific forms of asymmetric forecastability should not be inconsistent with the efficient market hypothesis since they do not have the capacity to exploit a profitable trading strategy. For instance, in the case Ct represents the vector of a given transaction cost variable integrating such factors as bid-ask spreads and brokers’ fees at time t. Let ft represent a given set of possible transactions at a given time, t that could encompass short sales barriers, limits on maximum holdings in specific stocks. The overall efficient market hypothesis can be represented as below; In this scenario, transactions cost might vary over a given period of time and should have come down in a much considerable manner for most of the assets. Thus, tests related to efficient market hypothesis would thus require the adoption of real-time data on aspects related to the transaction costs (Abergel &Politi, 2013). It is further noted that practically, the aspect of transactions costs can counter possible money machines given that the overall market impact of improving enormous positions technically translates to the profit opportunities that can never at any given point scaled up. In consequence, the validity of the strong of efficient market hypothesis is determined by the aspect related to learning and non-stationary of returns. This is attributed to the fact that investor’s perception and beliefs will always affect the underlying platform used in establishing distinctive stock prices (Abergel &Politi, 2013). This is irrespective of the fact that the underlying payoffs like dividends or even coupons are stationary in nature. The validity of efficient market hypothesis is sometimes inexplicable given that the process concerned with the selection of a successful forecasting model is indeed compounded by the extreme noisy platforms of numerous financial return trends as a whole (Sheikh & Noreen, 2012). A perfect example where this aspect can be perceived is present within the financial market anomalies. In respect, sufficient evidence exists ascertaining that the stock assets of given entities with high book-to-market values and a lower market capitalisation will likely pay a higher amount of returns in comparison to the standard models of risk premia (Sheikh & Noreen, 2012). To sum up the discussion above, it can be noted that the validity of efficient market hypothesis does not largely depend on the expert management of funds since individual and equity-based investors will likely have the same outcome or returns for that matter due to the unpredictability nature of securities market. Notably, the short-term momentum that include an under-reaction to new information is an empirical study that supported the perception that the overall stock market does not necessarily have any form of memory; meaning that the manner for which a stock price behaved in previous periods not necessarily provide a basis for determining its behaviour in the future periods References List Abergel, F. &Politi, M., 2013. Optimizing a basket against the efficient market hypothesis. Quantitative Finance, 13(1), pp.13-23. Campanella, F., Mustilli, M. & D’Angelo, E., 2016. Efficient Market Hypothesis and Fundamental Analysis: An Empirical Test in the European Securities Market. Review of Economics & Finance, 6, pp.27-42. Jain, V., 2012. An insight into behavioural finance models, efficient market hypothesis and its anomalies. Researchers World, 3(3), p.16. Malhotra, N., Tandon, K. & Tandon, D., 2015. Testing the Empirics of Weak Form of Efficient Market Hypothesis: Evidence from Asia-Pacific Markets. IUP Journal of Applied Finance, 21(4), p.18. Sheikh, M.J. & Noreen, U., 2012. Validity of efficient market hypothesis: Evidence from UK mutual funds. African Journal of Business Management, 6(2), p.514. Westerlund, J.& Narayan, P., 2013. Testing the efficient market hypothesis in conditionally heteroskedastic futures markets. Journal of Futures Markets, 33(11), pp.1024-1045. Westerlund, J., Norkute, M. & Narayan, P.K., 2015. A factor analytical approach to the efficient futures market hypothesis. Journal of Futures Markets, 35(4), pp.357-370. Zafar, S.M., Chaubey, D.S. & Bhatt, H.C., 2013. A study on efficient market hypothesis before recession: An empirical testing through random investing. ZENITH International Journal of Multidisciplinary Research, 3(4), pp.182-193. Read More