Efficient Market Hypothesis

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`A market is efficient with respect to a particular set of information if it is impossible to make abnormal profits by using this set of information to formulate buying and selling decisions.’

Critical Analysis

When we invest money into the stock market we do it with the intention of generating a return on the capital invested. Many investors try not only to make a profitable return, but also to outperform, or ‘beat the market’. However, market efficiency - championed in the efficient market hypothesis (EMH) formulated by Eugene Fama in 1970, suggests that security prices instantly and fully reflect all available information and that it would not be possible for an investor to make consistent excess profits. When new information
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If prices are predictable then competition between investors will eliminate them and arbitrage will force prices to their efficient values. Prices will only change on the basis of new information. Other evidence from studies measuring correlation of returns with returns in prior periods for various countries by Kendall & Alexander (Corhag 1987), Moore (Corhag,1987), Fama (1965), Jennergen (1975) suggested that only a very small element of historic return can explain current return.

Despite the strong evidence that stock movements are largely random there have been a few data anomalies exposed that call into question whether share prices do incorporate all historic data. Fran Cross (1973) and Gibbons and Hess found statistically significant evidence that share prices tend to fall on Mondays and rise on Fridays. This is popularly known as day of the week effect. The January Effect noted by Keim (1983) is a calendar-related anomaly in the financial market where financial security prices increase in the month of January. This creates an opportunity for investors to buy stock for lower prices before January and sell them after their value increases. This type of pattern in price behavior in the financial market supports the fact that financial markets are not fully efficient. De Bondt and Thaler (1985 and 1987) found that stocks that have fallen most in price during the previous three to five years will tend to yield excess returns over the following three to
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