Market Efficiency: Implications and Limitations of the Efficient Market Hypothesis | Saylor Academy (2024)

TERMS

• efficient markets hypothesis

  a set of theories about what information is reflected in securities trading prices

• information bias

  Information bias is a type of cognitive bias, and involves distorted evaluation of information. Information bias occurs due to people's curiosity and confusion of goals when trying to choose a course of action.

Investors and researchers have disputed the Efficient Market Hypothesis both empirically and theoretically. Behavioral economists attribute the imperfections in financial markets to a combination of cognitive biases such as overconfidence, overreaction, representative bias, information bias, and various other predictable human errors in reasoning and information processing. These have been researched by psychologists such as Daniel Kahneman, Amos Tversky, Richard Thaler, and Paul Slovic. These errors in reasoning lead most investors to avoid value stocks and buy growth stocks at expensive prices, which allow those who reason correctly to profit from bargains in neglected value stocks and the excessive selling of growth stocks.

Empirical evidence has been mixed, but has generally not supported strong forms of the Efficient Market Hypothesis. According to a publication by Dreman and Berry from 1995, 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. Ball's research had been accepted by Efficient Market theorists as explaining the anomaly in neat accordance with modern portfolio theory.

Speculative Economic Bubbles

Speculative economic bubbles 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 commented, "markets can remain irrational far longer than you or I can remain solvent". Sudden market crashes, like the one that occurred on Black Monday in 1987, are mysterious from the perspective of efficient markets, but allowed as a rare statistical event under the Weak-form of EMH. One could also argue that if the hypothesis is so weak, it should not be used in statistical models due to its lack of predictive behavior.

Transaction Costs

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-- in other words, 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.

Late 2000s Financial Crisis

The financial crisis of 2007–2012 has led to renewed scrutiny and criticism of the hypothesis. Market strategist Jeremy Grantham 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 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 chimed in, saying, "[it is] clear that among the causes of the recent financial crisis was an unjustified faith in rational expectations and market efficiencies".

The financial crisis has led Richard Posner, 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. Posner accused some of his Chicago School colleagues of being "asleep at the switch," claiming 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 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 decrease 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.