Comment on the Three Conditions on Market Efficiency

It is believed that Efficient Market Theory is based upon some fallacies and it does not provide strong grounds of whatever that it proposes. More importantly the Efficient Market theory is perceived to be too subjective in its definition and details and because of this it is close to impossible to accommodate this theory into a meaningful and explicit financial model that can actually assist investors in making the investment decisions (Andresso-O’Callaghan, B., 2007).

As Chapter 10 questions, if further evidence continues to surface that capital markets do not always behave in accordance with the efficient market hypothesis, then should we reject the research that has embraced the EMH as a fundamental assumption? In this regard we can return to earlier chapters of this book in which we emphasised that theories are abstractions of reality. Capital markets are made of individuals and as such it would not (or perhaps, should not) be surprising to find that the

Challenges are presented to people on the daily basis. What to eat, drink, where they have to go, who they need to see, and etc... These things all impact the decision making process and the decisions made. In financial decision making, highly successful people do not make investment decisions based on past sunk outcomes, rather by examining choices with no regard for past experiences; this approach conflicts with what one may expect. In addition to past experiences, there are several cognitive biases that influence decision making.

Loss aversion is the tendency for people to fear loss. The authors explain that this fear of loss can lead to unpredictable and often ruinous actions. It is shown that as the potential for loss increases, the stronger this force becomes. For example, many individuals encounter loss aversion when buying and selling stocks. During the Great Recession in the late 2000s, many stockholders experienced their stocks drastically drop in value. They feared if they sold their stocks, it would result in a tremendous loss of money. This fear of loss influenced many stockholders to hold on to their stocks hoping for them to rise back to their original value. Many stocks never increased in value after this incident. As a result, countless stockholders lost an immense amount of money. Loss aversion is an extremely strong force, however, it can be minimized by focusing on the big picture rather than short term consequences. If these stockholders had looked at the big picture and focused on studying the true value of each stock, they would have been able to minimize the amount of loss they would have to suffer.

This document is authorized for use only by Yen Ting Chen in FInancial Markets and Institutions taught by Nawal Ahmed Boston University from September 2014 to December 2014.

Allocating the ownership of economy’s stock capital is the primary role of capital market. In an ideal market the price would provide accurate signals for allocation of resources. Ideal market is one in which firm’s production-investment decisions and investor’s decision regarding securities will depend on the assumption that the security prices fully reflect available information at any point in time. A market in which prices always “fully reflect” available information is called efficient.1

sider BACKGROUND Efficient market theory examines how accurately stock prices signal resource allocation alloc and fully reflect all available information. Fama (1970) introduced the efficient market hypothesis stating there are three forms of efficiency: weak, semi strong, and strong. A market semi-strong, that incorporates all historical information is said to be weak form efficient, while one that responds to all publicly available informatio is semi-strong efficient. In a semiinformation -strong efficient market, prices instantly change to reflect publicly available information. A strong form market, strong responds to all information, both public and private. The hypothesis claims that achieving above average returns on a risk adjusted basis is impossible (Fama 1970). (Fama, The lowest level of market efficiency, weak form, states that the market only reacts to historical information. This means that no one can earn above normal returns based on published historical information; however, the market does not quickly react to new public or private information. It may be possible then, in a weak form efficient market, to obtain abnormal returns form using either new publicly available or private insider information (Fama 1970). (Fama, A semi-strong form market is more efficient that a weak form, as it reacts to publicly strong available new information quickly and share prices adjust to reflect the market’s reaction. share Obtaining

The Overconfidence Hypothesis describes the tendency of individual investors to trade excessively based on a mistaken belief that they can pick winners and losers better than investment professionals. Overconfidence is characterized by three main tendencies. First, overconfident investors tend to overreact to

When establishing financial prices, the market is usually deemed to be well-versed and clever. In a stock market, stocks are based on the information given and should be priced at the accurate level. In the past, this was supposed to be guaranteed by the accessibility of sufficient information from investors. However, as new information is given the prices would shift. “Free markets, so the hypothesis goes, could only be inefficient if investors ignored price sensitive data. Whoever used this data could make large profits and the market would readjust becoming efficient once again” (McMinn, 2007, ¶ 1). This paper will identify the different forms of EMH, sources supporting and refuting the EMH and finally

Thus, our first set of hypotheses predict a negative relation between overconfidence and both conditional and unconditional conservatism respectively.2 In addition, we examine whether these effects vary with the strength of external monitoring based on the argument in Kahneman and Lovallo [1993] that overconfidence or optimism is best alleviated by introducing an outside view. Thus, external monitoring could mitigate the predicted negative relation between overconfidence and conservatism. Our tests are based on a sample of 14,641 firm-years over 1993-2009 from S&P 1500 firms that have the available data needed to carry out our tests. Our primary measure of overconfidence is based on the timing of CEO option exercise following Malmendier and Tate [2005, 2008], Hirshleifer, Low, and Teoh [2010], and Campbell et al. [2011]. Intuitively, CEOs are under-diversified and should exercise their options and sell shares obtained from exercising options to minimize their exposure to idiosyncratic risk. However, an overconfident CEO

The more efficient the capital market is, the more likely the market will find its highest risk adjusted return. The efficiency of the capital markets is the “glue” that bonds the present value of a firm’s net cash flows,

Efficient Market Hypothesis has been controversial issues among researcher for decades. Until now, there is no united conclusion whether capital markets are efficiency or not. In 1960s, Fama (1970) believed that market is very efficient despite there are some trivial contradicted tests. Until recently, both empirical and theatrical efficient market hypothesis was being disputed by behavior finance economist. They have found that investor have psychological biases and found evidences that some stocks outperform other stocks. Moreover, there are evidences prove that market are not efficient for instance financial crisis, stock market bubble, and some investor can earn abnormal return which happening regularly in stock markets all over the world. Therefore, the purpose of this essay is to demonstrate that Efficient Market Hypothesis in stock (capital) markets does not exist in the real world by proofing four outstanding unrealistic conditions that make market efficient: information is widely available and cost-free, investor are rational, independent and unbiased, There is no liquidity problem in stock market, and finally stock prices has no pattern.

The efficient market, as one of the pillars of neoclassical finance, asserts that financial markets are efficient on information. The efficient market hypothesis suggests that there is no trading system based on currently available information that could be expected to generate excess risk-adjusted returns consistently as this information is already reflected in current prices. However, EMH has been the most controversial subject of research in the fields of financial economics during the last 40 years. “Behavioural finance, however, is now seriously challenging this premise by arguing that people are clearly not rational” (Ross, (2002)). Behavioral finance uses facts from psychology and other human sciences in order to

Discuss the implications of the paradox that although financial theory assumes that investors are rational in practive, few if any investors appear to approach investments decisions in a rational manner.

There are also other external factors that can have an effect. There are institutional firms that do “strongly believe that behavioural biases cause investors to over- or underreact to new information as sentiment and emotion cloud their judgment” (Roodt, 1). They acknowledge this with the hope that by recognizing its existence they are already doing at least a small part to combat biases in valuations for the analysts.