EFFICIENT MARKET HYPOTHESIS

Efficient Market Hypothesis



Efficient Market Hypothesis

Introduction

Computers and other online technology were earlier utilized to analyze and formulate the economic time series. The analysts and theorists had persistent belief in the outcome of technology to track the trends of stock prices and returns in boom and recession. This assumption was proved wrong as a result of experimentation and analysis done by Maurice Kendall in 1953 and no predictable stock prices pattern cold be found. Prices of stock market followed a random pattern. The economists began to analyze and assess the random walk as a predictor of efficient market. If the predictability of stock prices was that easy then stock markets would have become a gold mine for investors.

If market starts operating that efficiently then any good news or information pertaining to undervaluation or overvaluation of stock price shall immediately result into price increase or decrease. The movement of such information can be considered as unpredictable. The efficient market hypothesis suggests that market prices of stocks respond fairly to all information available to investors. The EFM theory was developed by Paul A Samuelson and Eugene F Fama in 1960s (Blume and Durlauf. 2007, pp. 1-28).

The theory of EFM has been consistently applied to various other models and fields of study pertaining to stock prices, rate of return, and financial markets to investigate pricing process. However, many behavioural economists argue that it is dependent on the counterfactual considerations of human behaviour. It demonstrates rational aspects of behaviour.

Discussion

Origin of EFM

The original concept of EFM was initially derived by Louis Bachelier during 1900s. His worked to evaluate the market prices of commodities to determine the randomness in fluctuation with respect to market prices. The random walk model was explained and introduced by Karl Pearson in 1905. It was also referred to as Drnnkard-walk concept. The researcher like Cowless conducted a research in order to exhibit the efforts of predicting the profitable securities in insurance companies and how these securities shall move in future. The results of the study revealed that no professional agencies possess any special skills in this regard. The same study was repeated by the researcher with the only difference of extending the time period. The results improved by 3.3% only in 1944.

The analyst Kendall, who utilized random walk model in his research during 1953 conducted a research to examine the stock of 22 British indices and American commodity prices to assess the price cycles. The research showed that the prices followed a random walk model irrespective of previous day's results. Same results have been found by Roberts in 1959 for American data.

The research and analysis work done by Fama exhibited that history tends to repeat itself. One can forecast the trends of stock prices on the basis of history. As per Fama, one cannot gain abnormal profits just by analyzing the historical trends, because the future price changes are independent. He also emphasized upon significance of fundamental analysis as it helps in assessing the intrinsic value of ...