Thursday, June 3, 2010
Is Efficient Market Hypothesis (EMH) loosing its ground?
The criticism against efficient market hypothesis has taken momentum after the recent financial crisis. While its validity to predict financial market behavior was questioned even during and after the Black Monday crash of 1987 and Tech Crash of 2000, the criticism has taken momentum after the recent crisis, mainly attributable to a misguided faith in this hypothesis that encouraged market participants to accept security prices as the best estimate of value rather than conduct their own investigation. See the hypes here and here, and an interview with Eugine Fama, inventor of EMH, defending the theory. Do these explanations make this hypothesis obsolete? Not certainly. The only problem with this hypothesis is the lack of advanced behavioral finance yet to be developed and incorporated into EMH to better explain the behavior of financial market participants when they make their transactions.
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It appears that after the latest recession, almost every economic theory and hypothesis is scrutinized and criticized. The problem with trying to prove or discredit the Efficient Market Hypothesis (EMH) is that there’s insufficient empirical evidence regarding it. The main premise of the EMH is that markets prices reflect all available information, i.e. the markets are informationally efficient. Most major players in the financial market do not subscribe to the EMH. Therefore, it is samewhat farfetched assertion that EMH helped to cause the recession. If current securities prices were the only information needed to make profitable trades, everyone would be investing by themselves, with no help from the established financial entities. That of course, doesn’t happen. Hedge funds, for instance, are able to make huge profits precisely because of their ability to seek out, analyze, and execute trades based on information not available to the avereage Joe. They employ large staff to process this information, often receiveing it even before the news media does. Even though not much emperical evidence exists regarding EMH, rational and intuitive economic logic seems to discredit it.
ReplyDeleteMichael Kinsley
If Fama is correct that hardly anyone believes the EMH then it shouldn’t be used as the scapegoat; however, if the Feds decisions regarding regulations were based on EMH then it should be considered even if analysts didn’t make their decisions based on EMH. I believe that EMH holds as long as it is utilized knowing that issues surrounding the principal-agency relationship as well as moral hazard and adverse selection may not be reflected in the security price. Also, it needs to be understood that EMH does not address future adverse behavior that might occur in the market. Economic/financial models, hypotheses, principles, etc. are tools designed to aide in intelligent decision-making. Human reasoning and logic must always be apart of our decision-making. There is no magic bullet.
ReplyDeleteAvadella White
First off, I must agree the notion that the EMH was responsible for the financial crisis is questionable at best. In short the EMH states that financial markets are informationally efficient; this implies that no one can receive returns in excess of the risk-adjusted market average. I can see how you could argue that these belief lead financial leaders to underestimate the danger of certain events in the market, but you cannot blame the EMH for the crisis. You can blame waves of deregulation, most of which were pushed by lobbyists pursuing corporate self interests, the irresponsibility of American consumers, predatory lending, “financial innovations”, greed, etc.
ReplyDeleteFama’s statement that no-one believes the EMH is well founded. As the previous post mentions, entire corporations are built on finding and exploiting inefficiencies in the market. There are many reasons for market imperfections; irrational behavior has a great impact on results, as does fraud, moral hazards, agency problems, adverse selection, and other behavior by market participants. This recession has been ground shaking and has caused all of us to question the foundation of our financial system. I believe this is a healthy reaction and may lead to a better understanding of what happened and how it can be prevented in the future.
-Matthew Moore
The EMH suggests that security prices reflect all available information (current and future) and are a true measure of the stock’s intrinsic value. Whether it’s losing it’s ground or not is a bit ambiguous and depends on opinion. I believe financial markets are efficient and somewhat irrational. To say that no one can outperform the market is a bit of an exaggeration. If people believed all markets are efficient, then no one would be willing to invest in risky assets. Fundamental and technical analysis are widely used market strategies in predicting future stock prices and has proven to yield positive returns.
ReplyDeleteEmotion also plays a critical role in asset prices. Currently, market volatility prices in a 2% move in either direction for major U.S. stock indexes. That is not an efficient market. It’s irritational behavior. Savvy investors will use the options market to profit on the volatility and buy downside protection on their investments in case an anomaly occurs. According to EMH, that is considered to be inefficient. I call it predicting market behavior.
Brian Frisch
In my opinion people are overlooking the main point of the EMH, it’s the EFFICIENT MARKET HYPOTHESIS meaning that it can only give the most accurate answer based off of the information that is presented. It is still then maintained that is an “educated guess” as to what will happen. So given that it is a hypothesis which states that the price of a security is a reflection of all available information about it and thus represents its true value and It states also that the current price of a security is the most appropriate measure of future returns, it can only be as accurate as it can at that exact moment in time. The fact that people are responding indifferently to the market now and are relatively afraid to make a move because the future looks bleek despite best efforts to change this, the hypothesis can only use this information to reflect the fears of the market that the people have. Until there can be an absolute hypothesis, formula or whatever that can indisputably say what will happen in the future (which will not happen), this hypothesis can be only taken as it is, an educated guess as to what will happen at that given point and will fluctuate as quickly as the information that is reported will.
ReplyDelete~Alysia J. Sturges
Some extremists have taken to the recent boom and bust of the stock market as evidence that the efficient market hypothesis is complete nonsense, because asset prices are moved by things other than market fundamentals. But one of the major ideas in behavioral finance is that irrational markets may still be impossible to arbitrage. The implication of the efficient markets hypothesis is that trying to pick the best stocks or bonds will not do better than buying an index fund. With this viewpoint it is easy to see why EMH will continue to garner such mixed reviews of its effectiveness or lack of.
ReplyDeleteThe CEO’s of the financial institutions found an easy way out by using an excuse of the Efficient Market Hypothesis and failed to predict the threat posed to the financial stability of the economy brought by the sub-prime backed securities. The banks and credit agencies underestimated the risks in real estate while the regulators failed to believe that the financial firms where offsetting their credit risks. The mistakes of the rating agencies / that of the financial firms of overleveraging the sub-prime securities cannot be that of the Efficient Market Hypothesis. Although the market was suspicious of the quality of securities based on the high yields despite their investment grade, the prospective buyers did not act on the trend and continued to take wrong decisions purchasing these securities
ReplyDeleteDuring the housing market bubble (2000-2007), all the major institutions (public & private) ignored the fact that rise in the home price index was way higher compared to the rise in median household income. The rise in the home price index was fuelled by the entry of the sub-prime mortgage borrowers, who till then had difficulty getting a mortgage. The mortgage lenders reduced the entry cost for mortgage based on one single assumption that house prices would always go up. (based on the fact that the home prices always went up in the last 40 years, except few minor exception years).
Even the government backed agencies like Fannie Mae & Freddie Mac also played a major role in increasing the home ownership of low-income families (mostly the sub-prime borrowers).
The unethical practices by mortgage lenders, who created special easy entry mortgage instruments for sub-prime borrowers, where the chances of default was very high were also based on the assumption that incase of default the bank could realize the loan by selling the home.
When the base assumption went wrong and the home prices started going down and default rates went up, the financial institutions started witnessing exponential losses, because of their high leverage.
Both government and private financial institutions are equally responsible for the crisis, because they were not prepared to handle drop in home prices and government did not have any regulations to oversee the risk taking by the financial institutions.
*****ANTARA MAJUMDER*****
The efficient-market hypothesis which was developed by Professor Eugene Fama through his published Ph.D. thesis in the early 1960 was widely accepted up until the 1990s, when as a result of its observed flaws in more prevalent expression of the beliefs of the until thing fringe group of behavioral finance economists, that became somewhat mainstream with their opinion that the “use social, cognitive and emotional factors of individuals and institutions performing economic functions, including consumers, borrowers and investors understanding should be considered and somehow integrated into the creation of the percieved value of market objects and would thereby help to avoid the “blind faith” belief that the market always adjusts itself.
ReplyDeleteThe market meltdown clearly demonstrated that when certain objects have been introduced into the system their underlying flawed structure may and will prevent the automatic and self adjusting nature that EMH once did.
By Renell Anderson
The efficient-market hypothesis which was developed by Professor Eugene Fama through his published Ph.D. thesis in the early 1960 was widely accepted up until the 1990s, when as a result of its observed flaws in more prevalent expression of the beliefs of the until thing fringe group of behavioral finance economists, that became somewhat mainstream with their opinion that the “use social, cognitive and emotional factors of individuals and institutions performing economic functions, including consumers, borrowers and investors understanding should be considered and somehow integrated into the creation of the percieved value of market objects and would thereby help to avoid the “blind faith” belief that the market always adjusts itself.
ReplyDeleteThe market meltdown clearly demonstrated that when certain objects have been introduced into the system their underlying flawed structure may and will prevent the automatic and self adjusting nature that EMH once did.
By Renell Anderson
I do believe in what Fama is saying it makes a lot of sense. If we attack a theory to try to use it as a scape goat for making mistakes, we are sadly mistaken. You see the efficient market hypothesis makes sense. Stock prices reflect past and current information regarding the corporation. You see recent crisis happened because of many corporations lying about information, and of course the stock prices reflected the change. We can easily point fingers and say well the efficient market hypothesis does not hold true because we can just adjust prices to make revenue. But thats just blaming the theory, when it's proving it's self correct based on our lies. We lied the stock prices reflected the markets lies, and then we had a crash.
ReplyDeletePetrica Molnar
Clearly the main question that has arisen after the recent economic downturn is whether the Efficient Market Hypothesis is still a valid, accepted way to understand, observe, and participate in markets? Well, certain economists had been asking the same thing after previous downturns, questioning the ability of the EMH to predict market behavior in the way it posits. According to our Professor, "the only problem with this hypothesis is the lack of advanced behavioral finance yet to be developed and incorporated into EMH to better explain the behavior of financial market participants when they make their transactions." I certainly agree with that in a sense, but I also think the EMH is primarily losing its ground mainly because it caused financial leaders to have a "chronic underestimation of the dangers of asset bubbles breaking". The only way to adapt the EMH is to stabilize public information in a way that prevents conflating market stability with the EMH. Basically, when publicly available information is unstable, the market can be just as unstable.
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