Efficient Market Theory

Idu

I know this is an economic term but Im more interested in the effect this idea has on the actual markets. For those who dont know the Efficient Market Theory states that financial markets are "informationally efficient", or that prices on traded assets, e.g., stocks, bonds, or property, already reflect all known information. The efficient-market hypothesis states that it is impossible to consistently outperform the market by using any information that the market already knows, except through luck

Basically it means that the market price is correct more often than not with all the information available.

Take for example the recent heavy flucuation on AIB's share price. Using the efficient market theory when the price fell to 30c on fear of nationalisation it was the correct price for the stock based on the available information. When the stock rebounded it was down to the news that nationalisation was not immenent.

All fairly straight forward. My question is this? With effecient market theory in effect does it exasserbate the swings in the market? Is it in fact an in-effecient theory because it does not accurately gauge the human reaction to the news and how that is put into effect on the market? Is it the cause for the boom and bust cycle in which we exist? Is there a viable alternative?

Time Magazine

Good thread, j_o_c.

The EMH marked a major shift is financial economics. Economists try to explain economic phenomena, be it why diamonds (which are useless) are worth more than water (necessary for life) or why stocks change prices from Monday to Tuesday.

I think it's best to start off by pointing out that economists haven't answered the last question yet. Nobody knows exactly why they change all the time. The reason for this is simple. There are millions of people trading shares, all over the world, for many different reasons. As this board sometimes shows, the reason they trade on Thursday instead of Wednesday can be essentially random.

However the whole field of financial economics isn't complete crap. It started out asking out why people invest. The most logical answer, prior to the speculation that happens today, is that they expect dividends to pay off for their investment. So in 1959 you had The Gordon Growth Model which basically states the price depends on expected dividends. About five years later emerged CAPM which stated that prices were determined by how risky the asset was.

Both of these are reasonable enough models. Gordon is a bit like PE ratio and CAPM has been given a bit more data-based support in recent years (link, but you'll need a degree in Economics to understand it). Neither however go near to explaining why stock prices change so much.

So along came the Efficient Market Hypothesis. It's a very simple theory that holds a lot of weight. Basically, it says prices change day-to-day because the market updates its valuation of a company from day-to-day. There's no "model" as such, just "news" (i.e. new information) that indicates the value of a share.

Thus when Anglo was nationalised, it showed the government doesn't mind interfering in markets and the "news" was that AIB/BoI might be nationalised. The price fell. When Brian Lenihan said "we're not gonna nationalise anything else", (despite previously having denied they were even going to re-capitalise any banks...) the "news" was that AIB/BoI were unlikely to be nationalised. The price rose.

Consequently, if the EMH is true, the lads on this forum are playing a mug's game. You cannot predict what AIB's share price will be tomorrow unless you know what the "news" will be, which by the definition of "new", you can't.

Now EMH requires the assumption that the market updates its valuation of companies rationally. This is pretty much its only assumption.

It's also a load of crap, which I'll get to now.

janets_on_clubs wrote: »

With effecient market theory in effect does it exasserbate the swings in the market?

I don't think so. EMH says traders update their valuations rationally. If they were doing so rationally, it wouldn't matter what economic theory is doing the rounds today. At any rate, I don't think traders pay much heed to economic theory.

Is it in fact an in-effecient theory because it does not accurately gauge the human reaction to the news and how that is put into effect on the market?

That's an excellent question. There's a load of evidence that EMH is crap. It has been shown that buying a portfolio of poor-performing stocks will bring above-average returns (an argument for buying AIB, BoI etc?), but it has also been shown that if you change your time-horizon, buying a portfolio of the best-performing stocks also brings above-average returns. If this doesn't make sense, then good. It's because people aren't rational and don't update their valuations of companies correctly. The react like humans and price like humans; not rational economic agents.

Is it the cause for the boom and bust cycle in which we exist?

If you're asking this, I don't think you quite grasp EMH. EMH says "the price is right today, and will properly update itself tomorrow." So when bad news comes in (recession, deficit, AC/DC making a come-back) the market lowers its valuation. It's all about "the news".

Is there a viable alternative?

Thankfully, yes.

Look up Behavioural economics, of which behavioural finance is a particularly interesting subset. If you want some recommendations for readings in the area, or if you've any questions, let me know.

Diarmuid

Doesn't the EMT lead to the conclusion that the only sensible investment tecnhnique is to buy index funds and hold. Now isn't this a very good test of how good the EMT is in practice? ie compare managed fund performances against the market for the past 10/20/30 years. When you do the index funds beat 80% of the managed funds with that percentage increasing the longer you hold. Any comments?

Nermal

janets_on_clubs wrote: »

With effecient market theory in effect does it exacerbate the swings in the market?

It's just a theory, it can't exacerbate anything. Wild swings as new information is discovered are perfectly consistent with the EMH.

soddy1979

I am aware of the large role of technical analysis in trading currency, but does it play such a large part in trading securities also?

If so, would it not be the case that fundamentals traders who follow EMH need to take note of the technicals anyway, where both could be getting different signals on the same stocks?

And, if one bases there trading on fundamental factors, surely there are a lot of bargains in the markets at the moment, with fear overtaking other factors as a driver of price?

econ09

Surely traders don't believe in the EMH? If they do, are they saying their career and ability is down to pure luck???

Hanley

The EMH is something I've always disliked... They couldn't even create a pure model, they had to add qualifications such as strong form, semi-strong form etc etc to explain why the market didn't behave the way it "should".