Efficient-Market Hypothesis

Malkiel's efficient market hypothesis: "No one can consistently predict either the direction of the stock market or the relative attractiveness of individual stocks, and thus no one can consistently obtain better overall returns than the market. And while there are undoubtedly profitable trading opportunities that occassionally appear, these are quickly wiped out once they become known. No one person or institution has yet to produce a long-term, consistent record of finding money-making, risk-adjusted individual stock-trading opportunities, particularly if they pay taxes and incur transaction costs." (pg 246)

---

-Malkiel's efficient market hypothesis has three versions.

1. Weak form- You can not predict future stock prices on the basis of past stock prices, therefore stock prices behave very much like a random walk.
2. Semi-strong form- You can not even use published information to predict future prices. No public information will help an analyst select under-valued securities because market prices already include public information such as balance sheets, income statements, and divivends.
3. Strong form- Nothing, not even unpublished developments, can be of use in predicting future prices; everything that is known, or knowable, has already been reflected in the present stock price. Information contained in past prices or any publicly available information is assimilated into market prices. These prices adjust so rapidly that if some degree of mispricing exists, it does not persit for long.

Example:

• A student comes across a $100 bill lying on the ground and stops to pick it up. The professor says, "Don't bother, if it were really a $100 bill, it wouldn't be there."

This example illustrates what financial economists, such as Malkiel, mean when they state that markets are efficient. $100 bills are not lying around on the ground because markets are so efficient that they do not allow for investors to earn above-average returns without accepting above-average risks. If predictable patterns are present in the stock market and if market prices are determined by irrational investors, then professional investment managers clearly ought to be able to use them to be able to use them to beat a simple index fund. However, a large body of evidence suggests that professional investment managers are not able to outperform index funds that simply buy and hold a diversified portfolio.

Main Points:

• Active mutual fund managers were unable to add value and tended to underperform the market

• In the past decade, about 3/4 of actively managed funds failed to beat the S&P 500 Index

• The median large capitalization professionally managed equity fund has underperformed the S&P 500 by almost 2 percentage points

---

Richard Roll, an academic economist, agrees with Malkiel's market efficient hypothesis after unsuccessfully investing his own money in theories that supposedly predicted market prices. "I have attempted to exploit a whole variety of strategies supposedly documented by academic research, and I have yet to make a nickel on any of these alleged market inefficiencies . . . I have to keep coming back to my original point that a true market inefficiency ought to be an exploitable opportunity. If there's nothing investors can exploit in a systematic way, then it's very hard to say that information is not being properly incorporated into stock prices. Real money investment strategies don't produce the results that academic papers say they should." (pg. 273)

---

Inconsistencies with Malkiel's theory?

There are examples historically in which pyschology and speculative group mania seemed to dominate the pricing process (ie. Tulip bulb craze in 17th century Holland and Internet bubble of 21st century), and seem inconsistent with the efficient market theory. However, in both of these cases the market eventually corrects any irrationality. Markets are capable of getting 'irrationally exuberant' and this attracts investors, which creates speculative crazes, but eventually the true value is recognized by the market. Although the market may not always be rational in the short run, it always is rational over the long haul.

---

Random Walk | Speculative Bubbles | Fundamental Analysis | Technical Analysis | Efficient-Market Hypothesis | Non-Random Walk Theory | Market Efficiency vs. Behavioral Finance