Arnold (2013) states: ‘an
efficient capital market occurs when securities, for example, shares,
rationally reflect all the available information.’ When information comes to light, this will
swiftly and rationally be reflected in the share price. According to the efficient market hypothesis
(EMH), no trader can make a greater return than the risk taken for buying that
share. If this was to happen, it would
be occurring by chance.
Fama (1970), an important researcher in the area of capital
market efficiency separates efficiency into three different levels or categories:
Strong Form – Publicly
and Privately held information is reflected in Share Price
Semi-Strong Form –Share
price fully reflects all relevant publicly available information
Weak Form –Share
price fully reflects information in historical prices
In his paper in 1953, Maurice Kendall explored the movements
in stock prices over time, looking for any trends or patterns as he went about
his work. In short, he was unable to
find any trends in the fluctuations of the stock price and concluded that the
stock price followed a ‘random walk.’
In the financial world, there seems to be a general view
that stock markets are efficient with investors steadily shifting assets from
actively managed funds into passive managed funds. Actively managed funds have been severely
underperforming the stock market. At the
end of 2013, index funds accounted for one dollar of every five invested in US
mutual funds overall and more than one-third of the assets in US equity funds
(Pozen and Hamacher, 2015). The move to
passively managed funds signals that there is strong support for the Efficient
Market Hypothesis.
There are several arguments against the Efficient Market
Hypothesis. Malkiel (2003) argues that
investors can collectively make mistakes and some market participants are less
than rational. As a result, pricing
irregularities and even predictable patterns in stock returns can appear over
time and even persist for short periods.
Malkiel (1980) also supported the view of Grossman and Stigliz who
stated that the market cannot be perfectly efficient, or there would be no
incentive for professionals to uncover the information that gets so quickly
reflected in market prices.
Furthermore, the issue of Insider Trading is common in the business
world today. How can stock markets be
efficient if this is happening behind the closed doors of listed companies? If
information can be accessed by internal investors but not by external
investors, surely a capital market cannot be deemed completely efficient. Take for example the recent case of the
former financial analyst for the US pharmaceutical giant Merck & Co. Inc.
who pleaded guilty to charges related to insider trading. His plot focused on using inside information
about various intended corporate acquisitions to purchase shares in the company
(Calia, 2015).
To a degree, there is strong evidence that efficient capital
markets exist. However it is impossible
to determine if capital markets are fully efficient. If investors were only relying on publicly
available information, I think they would quickly lose the ‘thrill’ of
investing in the stock market.
References
Arnold, G. (2013). Corporate financial management. (5th ed.) Harlow, England: Financial Times/Prentice Hall
Calia, M. (2015). Former Merck Analyst Pleads Guilty to Insider Trading Charges. WSJ. Retrieved 20 February 2015, from http://www.wsj.com/articles/former-merck-analyst-pleads-guilty-to-insider-trading-charges-1424446449
Fama, E. (1970). Efficient Capital Markets: A Review of Theory and Empirical Work. The Journal Of Finance, 25(2), 383. doi:10.2307/2325486
Grossman, S. J., & Stiglitz, J. E. (1980). On the impossibility of informationally efficient markets. The American economic review, 393-408. Retrieved 20th February from http://www.jstor.org
Malkiel, B. (2003). The Efficient Market Hypothesis and Its Critics. Journal Of Economic Perspectives, 17(1), 59-82. doi:10.1257/089533003321164958
Pozen, R., & Hamacher, T. (2015). Has the death knell of active management been rung too soon?. The Financial Times. Retrieved 18th February 2015 from http://www.ft.com/cms/s/0/e153fbc6-a644-11e4-89e5-00144feab7de.html#axzz3ZNKMrKJ4
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