Problems with the Efficient Market Hypothesis There are many arguments which have been used to discredit the EMH over the decades. Many focus on market anomalies such as the January effect where the price of small‐cap stocks will rise Abnormally during the first few days of trading in a new year (Pietranico & Riepe [2004]), or the Existence of long‐term successful investors such as Warren Buffet or George Soros, but there are far more problematic prima‐facie problems at a theoretical level. This paper shall concentrate on the three most important of these. Problem 1: Information Asymmetry One obvious requirement of EMH is that new information must circulate around all investors very quickly indeed if even semi‐strong EMH is to be possible. Good information is costly to generate and rapidly loses value as more people learn it (Chen [2005]), so there is an obvious vested interest against the widespread sharing of information. Empirical studies show that good information tends to be hoarded by investors – indeed, often there are even deliberate attempts at disseminating misinformation by one investor to other investors! (Akerlof [1970]) Yet the empirical record (Patell & Wolfson [1984]) would suggest that news is incorporated into price within ten minutes despite that substantial disparities in investor access to information exist. This problem of how the market is really so able to adjust its prices so accurately and so quickly when such information asymmetry exists has occupied a lot of recent research which we shall come to shortly. Problem 2: Investors are not rational Investors are people, and they don’t always behave rationally. Just like the fashion for skirt lengths, markets also undergo fashionable trends – certain industries or stocks will become fads, leading to investor over‐confidence or under and market bubbles and crashes. In 1996 in response to an ever rising bull market in the US stock market, Federal Reserve chairman Alan Greenspan warned against “irrational exuberance” – yet those who heeded his words lost millions as the market sped up even faster as the crash everyone knew was coming came closer. As Keynes once said, Markets can remain irrational longer than you can remain solvent. Problem 3: Stock market crashes happen far too often According to EMH, substantial stock market movements should be rare and not severe due to the Properties of normally distributed randomness. Unfortunately, as we have learned to our cost, Severe market crashes are a fundamental feature of competitive markets in general – as Ormerod (2005) correctly points out, failure & extinction is the statistical norm rather than the exception.
Posted on: Mon, 25 Nov 2013 17:58:52 +0000
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