Requirements:
1000 word essay- efficient market hypothesis
It is a 1000 word essay regarding the topic: Efficient Market hypothesis. You have to explain the three forms of EMH – The weak form, semi strong form and strong form, and how to test the three forms with academic literature and empirical evidences. The attached PPT is the guideline/ structure for the essay. The information can be taken from the PPT. and use the key academic papers provided in the ppt. Harvard referencing format.
Answer:
Research suggests that most people tend to overreact to unexpected news and dramatic events. Bond and Thaller have initiated a study to find whether such behavior matters in the stock market. People indeed tend to give more weightage to recent information than prior data. One of the earliest observation in stock markets about overreaction was done by J.M. Keynes, who studied the daily variations in the returns of investments have more, and preposterous, effect on the stock mark (Keyens, 1964). Moreover, a study done by William concluded that prices rely too much on earning capacity of the company, rather than on the long term dividend-paying capacity of the company (Williams, 1956).
Additionally, a study by Kleidon showed that the fluctuations in price are strongly correlated with the changes in earnings in the subsequent year, which depicts a clear pattern of an overreaction (Kleidon, 1981). Another study showed that the stock splits after an increase in volatility of investment returns is also linked to overreaction (Penman., 1983). For their findings, Bond and Thaller collected a portfolio of stocks that experienced extreme losses and extreme gains, for five years. They name it “winner’ and ‘loser.’ However, the portfolio was formed solely on past earnings on the investment. Hence, their study was based on three types of returns market-adjusted excess returns, residuals, and excess returns measured through CAPM. Moreover, the ‘loser’ portfolio is no different than the winner portfolio, in terms of the market value of equity, financial leverage, and dividend yield.
Nonetheless, the result showed that the ‘loser’ portfolio of the 35 stocks outperformed the market indexby more than 19.6%, thirty-six months after the portfolio was created. However, the ‘winner’ portfolio gave poor result than the market index by 5%; the difference of extreme portfolio was 24.6%. Furthermore, the overreaction effect was skewed – that is, it was much larger for ‘loser’ than for ‘winner.’ Most of the surfeit returns were calculated in January of each year. In month 1, 13, and 25, the ‘loser’ portfolio’s returns were 8.1%, 5.6%, and 4.0% respectively. Additionally, Bond and Thaller found that most of the overreaction has happened during the second and third years. Every December, both the portfolios are formed on the basis of previous residuals. Persistently, ‘loser’ portfolios earn higher returns in January, and the ‘winner’ portfolio earn comparatively fewer returns. This January phenomenon may occur because investors may wait years before comprehending dropping returns and the seasonal trends of the market. ‘Loser’ portfolio was less risky as well (THALER, 1985)
The Efficient Market Hypothesis (EMH) is an investment theory that elucidates that an investor might get lucky by achieving higher returns in the short run. Still, in the long term, he cannot obtain a return on his investment more significant than the market average. The main idea of the theory is that a stock price always reflects its real value. Moreover, Efficient Market Hypotheses gives no merit to technical analysis. The reason is that technical analysis is solely based on historical data of the stock, which, if Efficient Market Hypotheses holds, is reflected in the current price. Technical analysis is based on the investors’ anticipation of predictable patterns based on past performance. However, Efficient Market Hypotheses that even the investors’ sentiment is reflected in the current price.
Additionally, previous prices and returns have no relation to future returns and price. Therefore, there is no point in adopting technical analysis. According to Efficient Market Hypotheses, the best approach an investor can choose is to invest in a low-price passive portfolio.
Furthermore, fundamental analysis is based on a company’s financial information such as the income statement and balance sheet to evaluate the stock price. Under the assumptions of strong Efficient Market Hypotheses, information is depicted in the stock price. There information known to private and the public are the same, and there is no superiority. In this scenario, fundamental analysis has no use. Because the stock price already reflects the intrinsic value. Under the assumption of semi-strong Efficient Market Hypotheses, the information knows to the public is already reflected in the stock price. The company’s financials are aligned with the stock price. So there is limited merit to fundamental analysis in such cases. However, under the assumption of weak Efficient Market Hypotheses, only the market information is reflected in the stock price. If a company announces a big deal or its annual reports, it is immediately reflected in the stock price. With such a scenario, there is room for fundamental analysis to work when it is based on an information advantage. With the merits of both the techniques discussed, one can formulate that if Efficient Market Hypotheses assumptions hold, then fundamental analysis has more potential as compared to technical analysis.
The strong form version of Efficient Market Hypotheses has little merits. But, The Strong form efficiency is reflected in a study done on active investment funds, by Michael Jensen, who evaluated the performance of 115 investment funds. The study indicated that 58 out of 115 funds gave below the market returns. The deviation of ten years’ back from the line market average was -2.5%. The strong form efficiency holds the belief that no data, whether private or public, can alter the returns for an investor because they are already contemplated in the price. Inside information can help an investor in the semi-strong form of Efficient Market Hypotheses, but in case of strong Efficient Market Hypotheses, holding on to private information will do no good.
Even though under the assumption energetic form efficiency, all the information is displayed, there are still some ways to perform better than the market. For example, analyzing companies with a low P/E ratio produce higher returns. Moreover, the neglected firm effect implies that companies that are analyzed by market analysts are often priced wrongly. The January effect studied by Bond and Thaller showed that portfolios tend to have higher returns in January.
References
Keyens, J. M., 1964. The General Theory of Employment, Interest and Money, London: s.n.
Kleidon, A. W., 1981. “Stock Prices as Rational Forecasters of Future Cash Flows, s.l.: Graduate School of Business, University of Chicago.
Penman., J. A. O. a. S. H., 1983. Variance Increases Subsequent to Stock Splits: An Empirical, s.l.: Graduate School of Business, Columbia University.
THALER, W. F. M. D. B. a. R., 1985. Does the Stock Market Overreact?, s.l.: s.n.
Williams, J. B., 1956. The Theory of Investment Value, s.l.: Amsterdam .
