The weak make the assumption that current stock prices reflect all available information. It goes further to say past performance is irrelevant to what the future holds for the stock. Therefore, it assumes that technical analysis can't be used to achieve returns. The semi-strong form of the theory contends stock prices are factored into all information that is publicly available.
Therefore, investors can't use fundamental analysis to beat the market and make significant gains. In the strong form of the theory, all information—both public and private—are already factored into the stock prices.
So it assumes no one has an advantage to the information available, whether that's someone on the inside or out. Therefore, it implies the market is perfect, and making excessive profits from the market is next to impossible. While it may sound great, this theory doesn't come without criticism. First, the efficient market hypothesis assumes all investors perceive all available information in precisely the same manner.
The different methods for analyzing and valuing stocks pose some problems for the validity of the EMH. If one investor looks for undervalued market opportunities while another evaluates a stock on the basis of its growth potential, these two investors will already have arrived at a different assessment of the stock's fair market value. Therefore, one argument against the EMH points out that, since investors value stocks differently, it is impossible to determine what a stock should be worth under an efficient market.
Proponents of the EMH conclude investors may profit from investing in a low-cost, passive portfolio. Secondly, no single investor is ever able to attain greater profitability than another with the same amount of invested funds under the efficient market hypothesis. Since they both have the same information, they can only achieve identical returns.
But consider the wide range of investment returns attained by the entire universe of investors, investment funds , and so forth. According to the EMH, if one investor is profitable, it means every investor is profitable. But this is far from true. Thirdly and closely related to the second point , under the efficient market hypothesis, no investor should ever be able to beat the market or the average annual returns that all investors and funds are able to achieve using their best efforts.
This would naturally imply, as many market experts often maintain, the absolute best investment strategy is simply to place all of one's investment funds into an index fund. This would increase or decrease according to the overall level of corporate profitability or losses. But there are many investors who have consistently beaten the market.
Warren Buffett is one of those who's managed to outpace the averages year after year. That would be impossible, as it takes time for stock prices to respond to new information. The efficient hypothesis, however, doesn't give a strict definition of how much time prices need to revert to fair value. Moreover, under an efficient market, random events are entirely acceptable, but will always be ironed out as prices revert to the norm. But it's important to ask whether EMH undermines itself by allowing random occurrences or environmental eventualities.
There is no doubt that such eventualities must be considered under market efficiency but, by definition, true efficiency accounts for those factors immediately. In other words, prices should respond nearly instantaneously with the release of new information that can be expected to affect a stock's investment characteristics.
So, if the EMH allows for inefficiencies, it may have to admit that absolute market efficiency is impossible. Although it's relatively easy to pour cold water on the efficient market hypothesis, its relevance may actually be growing. To test for semi-strong-form efficiency, the adjustments to previously unknown news must be of a reasonable size and must be instantaneous.
To test for this, consistent upward or downward adjustments after the initial change must be looked for. If there are any such adjustments it would suggest that investors had interpreted the information in a biased fashion and, hence, in an inefficient manner.
In strong-form efficiency, share prices reflect all information, public and private, and no one can earn excess returns. If there are legal barriers to private information becoming public, as with insider trading laws, strong-form efficiency is impossible, except in the case where the laws are universally ignored.
To test for strong-form efficiency, a market needs to exist where investors cannot consistently earn excess returns over a long period of time. The limitations of EMH include overconfidence, overreaction, representative bias, and information bias. Investors and researchers have disputed the Efficient Market Hypothesis both empirically and theoretically. Behavioral economists attribute the imperfections in financial markets to a combination of cognitive biases such as overconfidence, overreaction, representative bias, information bias, and various other predictable human errors in reasoning and information processing.
These errors in reasoning lead most investors to avoid value stocks and buy growth stocks at expensive prices, which allow those who reason correctly to profit from bargains in neglected value stocks and the excessive selling of growth stocks. Empirical evidence has been mixed, but has generally not supported strong forms of the Efficient Market Hypothesis.
In an earlier paper Dreman also refuted the assertion by Ray Ball that these higher returns could be attributed to higher beta. Speculative economic bubbles are an obvious anomaly, in that the market often appears to be driven by buyers operating on irrational exuberance, who take little notice of underlying value. These bubbles are typically followed by an overreaction of frantic selling, allowing shrewd investors to buy stocks at bargain prices.
One could also argue that if the hypothesis is so weak, it should not be used in statistical models due to its lack of predictive behavior.
Further empirical work has highlighted the impact transaction costs have on the concept of market efficiency, with much evidence suggesting that any anomalies pertaining to market inefficiencies are the result of a cost benefit analysis made by those willing to incur the cost of acquiring the valuable information in order to trade on it. Any test of this proposition faces the joint hypothesis problem, where it is impossible to ever test for market efficiency, since to do so requires the use of a measuring stick against which abnormal returns are compared— in other words, one cannot know if the market is efficient if one does not know if a model correctly stipulates the required rate of return.
Consequently, a situation arises where either the asset pricing model is incorrect or the market is inefficient, but one has no way of knowing which is the case. The financial crisis of — has led to renewed scrutiny and criticism of the hypothesis.
The financial crisis has led Richard Posner, a prominent judge, University of Chicago law professor, and innovator in the field of Law and Economics, to back away from the hypothesis and express some degree of belief in Keynesian economics. Perfect positive or negative correlations are rare. Correlation can be used to gain perspective on the overall nature of the larger market.
It was very difficult to pick stocks that outperformed the broader market during that period. It was also hard to select stocks in different sectors to increase the diversification of a portfolio. Investors had to look at other types of assets to help manage their portfolio risk. On the other hand, the high market correlation meant that investors only needed to use simple index funds to gain exposure to the market, rather than attempting to pick individual stocks.
Correlation is often used in portfolio management to measure the amount of diversification among the assets contained in a portfolio. Modern portfolio theory MPT uses a measure of the correlation of all the assets in a portfolio to help determine the most efficient frontier. This concept helps to optimize expected returns against a certain level of risk. Including assets that have a low correlation to each other helps to reduce the amount of overall risk for a portfolio.
Still, correlation can change over time. It can only be measured historically. Two assets that have had a high degree of correlation in the past can become uncorrelated and begin to move separately. This is one shortcoming of MPT; it assumes stable correlations among assets. During periods of heightened volatility, such as the financial crisis, stocks can have a tendency to become more correlated, even if they are in different sectors. International markets can also become highly correlated during times of instability.
Investors may want to include assets in their portfolios that have a low market correlation with the stock markets to help manage their risk. Unfortunately, correlation sometimes increases among various asset classes and different markets during periods of high volatility. The stock market was very concerned with the continuing volatility of prices for oil.
As the price of oil dropped, the market became nervous that some energy companies would default on their debt or have to ultimately declare bankruptcy. Choosing assets with low correlation with each other can help to reduce the risk of a portfolio.
For example, the most common way to diversify in a portfolio of stocks is to include bonds, as the two have historically had a lower degree of correlation with each other.
Investors also often use commodities such as precious metals to increase diversification; gold and silver are seen as common hedges to equities. Finally, investing in frontier markets countries whose economies are even less developed and accessible than those of emerging markets via exchange-traded funds ETFs can be a good way to diversify a U.
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