Criticism of Efficient Market Hypothesis (EMH)

There have been several criticisms of the efficient market hypothesis ranging from market anomalies to information asymmetry. The efficient market hypothesis applies to assets that trade on the financial market such as stocks, stock options, bonds, and other types of options.

There are three different types of efficient market hypothesis and all three indicate that an investor cannot consistently outperform the market.

Although the EMH was highly accepted in the 1970s and 80s when it became increasingly popular, further research and subsequent observations by economists and market analysts have led to the emergence of some criticisms of the efficient market hypothesis which we shall discuss hereafter.

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The efficient market hypothesis has been attributed to a 1970 review of the capital market by Eugene F. Fama titled, “Efficient Capital Markets: a Review of Theory and Empirical Work.” The work emphasized the impossibility of consistently outperforming the market provided that all investors are privy to the same information.

It indicated that the study of past stock prices aimed at predicting future prices, that is, technical analysis, is not useful in an efficient market. This is because stock prices are randomly assigned based on changing information which in most cases change daily.

Additionally, fundamental analysis which entails studying financial information cannot aid an investor in generating higher-than-average returns since all investors have equal access to all information in an efficient market.

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Criticism of efficient market hypothesis

1. Market anomalies
2. Behavioral biases and valuation anomalies
3. Market frictions
4. Information asymmetry
5. Extreme economic events

Market anomalies

The efficient market hypothesis has been criticized for not taking into account market anomalies that have become a common occurrence in the market.

For instance, the efficient market hypothesis posits that once new information is available, the prices of stocks on the stock market are supposed to instantaneously reflect the new information.

However, Bernard V. L. in his 1993 paper, Stock price reaction to earnings announcements: A summary of recent anomalous evidence and possible explanations asserts that stock prices take about 6 months to fully adjust to new information provided by earnings announcements by businesses.

Additional market anomalies that contradict the efficient market hypothesis include:

• Standard & Poor’s (S&P) Index effect whereby stocks that get included in the index have their stock price getting increased. This should not be so if the efficient market hypothesis is effective as only new information about a company is supposed to affect its stock price.
• The January effect indicates higher mean returns on stocks and bonds in January. This has been backed up by decades of evidence from several scholars such as M.S. Rozeff, W.R. Kinney, and W.F. Maxwell. It also contradicts the EMH as there is no clear explanation for these higher returns.
• Pre-holiday effect where returns on assets are usually higher the day before a holiday.
• Turn of the month effect where stock returns have been observed to be higher within the first three and last trading days of the month.

In addition to the above, stock market returns are positively affected by good weather. A study of stock markets in 26 countries from 1982 to 1997 by Hirshleifer D. and T. Shumway found a positive correlation between sunshine and stock market returns.

Furthermore, stocks of companies with low price-to-earnings (PE) ratios and those of smaller companies have been found to outperform stocks of companies with higher PE ratios and larger companies respectively.

All these indicate the inadequacy of the efficient market hypothesis.

Behavioral biases and valuation anomalies

Another criticism of the efficient market hypothesis is its assumption that all investors will use the available information in the same way and come to the same conclusion about a stock’s value. In reality, however, investors use different metrics when valuing stocks.

For instance, while analyzing the same set of information, one investor may decide that a stock is undervalued and hence, a good investment based on the assumption that they will gain from the stock when the market adjusts to reflect its actual value.

Another investor may consider the same stock as rightly valued and having no growth potential. As a result of this difference in valuation, it becomes impossible to determine the actual worth of the stock accurately. Hence, disproving the efficient market hypothesis.

Additionally, due to behavioral bias as pertains to personal preference and differences in decision-making, some investors may choose to take on more risky investments which mostly have higher returns. This is another clear contradiction of the EMH because if the hypothesis holds true, all investors are supposed to have the same level of return on investment.

Market frictions

An additional criticism of the efficient market hypothesis is the market frictions such as regulations, transaction costs, information glitches, taxes, and all other impediments that have a direct or indirect impact on the market.

In an efficient market, these market frictions do not exist as assets are bought and sold at their exact market value without transaction fees or payment of taxes on profits. It is also considered a free market where information is the major driver of price.

In reality, such a market does not exist because the government often sets rules that govern transactions in a bid to protect investors. Taxes and other transaction fees also apply to different degrees based on the asset class and level of return obtained.

Information asymmetry

Information is the major driver of price in an efficient market, it determines the fair market value of the stocks as well as the average returns that investors get. This is another point of the efficient market hypothesis that has been largely criticized due to information asymmetry.

This suggests that even if all investors are exposed to the same level of information, some investors are still bound to deduce more meaning from the available information than others. As a result of this, these investors are better equipped when making investment decisions and tend to make above-average returns on their investments.

One clear example of an investor who seems to have mastered the market over the years and has consistently made above-average returns on his investments is Warren Buffet. This brings to question the efficient market hypothesis assertion that investors cannot outperform the market consistently in the long term.

Extreme economic events

Extreme economic events such as the stock market crash of 1987 and the global financial crisis of 2007/2008 are perhaps some of the greatest points of criticism of the efficient market hypothesis. This is because if the EMH were to hold true, bubbles would not exist where the prices of securities such as bonds and stocks are extremely above their true market value.

However, due to the existence of financial bubbles and its subsequent burst in October 1987, stock prices of several stocks crashed. This is an abnormal occurrence because if the efficient market hypothesis holds true, the prices of stocks are supposed to be accurate, hence, the stock market should not crash under any condition.

Additionally, the efficient market hypothesis posits that the best way to invest and earn good returns in the long run is by investing in mutual funds and indexes. This position has been criticized due to the crash of the Dow Jones Industrial Average (DJIA). Stocks in the DJIA were devalued by about 22.7% due to the crash of the stock market in 1987.

These anomalies which have occurred due to the market’s inability to curtail and adequately translate investor behavior that created the bubbles have indicated the inability of the efficient market hypothesis to always hold true.

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Additionally, the time frame it takes for stock prices to respond to new information such as earnings calls has also brought to question the efficacy of the efficient market hypothesis.

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Conclusion

Criticism of the efficient market hypothesis includes the occurrence of extreme economic events, market anomalies, and behavioral biases. Additional EMH criticisms include valuation anomalies, information asymmetry, and market frictions.

Critics of the efficient market hypothesis suggest that financial institutions and corporations have been able to decrease the efficiency of financial markets by reducing the accuracy of the information they make available to the public and through the creation of new products whose valuation processes are not straightforward.

Last Updated on January 20, 2024 by Blessing Peter Titus