Chapter 6 Are Financial Markets Efficient?

Throughout our discussion of how financial markets work, you may have noticed that the subject of
expectations keeps cropping up. Expectations of returns, risk, and liquidity are central elements in the
demand for assets; expectations of inflation have a major impact on bond prices and interest rates;
expectations about the likelihood of default are the most important factor that determines the risk
structure of interest rates; and expectations of future short-term interest rates play a central role in
determining the term structure of interest rates. Not only are expectations critical in understanding
behavior in financial markets, but as we will see later in this book, they are also central to our
understanding of how financial institutions operate.

In this chapter we examine the basic reasoning behind the efficient market hypothesis in order to explain
some puzzling features of the operation and behavior of financial markets. Theoretically, the efficient
market hypothesis should be a powerful tool for analyzing behavior in financial markets. But to establish
that it is in reality a useful tool, we must compare the theory with the data.

The Efficient Market Hypothesis

To understand how expectations affect securities prices, we need to look at how information in the market
affects these prices. To do this we examine the efficient market hypothesis (also referred to as the theory
of efficient capital markets), which states that prices of securities in financial markets fully reflect all
available information.

You may recall from Chapter 3 that the rate of return from holding a security equals the sum of the capital
gain on the security (the change in the price) plus any cash payments, divided by the initial purchase price of
the security:

Let’s look at the expectation of this return at time t, the beginning of the holding period. Because the
current price and the cash payment C are known at the beginning, the only variable in the definition of the
return that is uncertain is the price next period, Pt+1. 1 Denoting the expectation of the security’s price at
the end of the holding period as 𝑃𝑡+1 , the expected return 𝑅 𝑒 is
𝑒
𝑃𝑡+1 − 𝑃𝑡 + 𝐶
𝑅𝑒 =
𝑃𝑡
The efficient market hypothesis views expectations as equal to optimal forecasts using all available
information. An optimal forecast is the best guess of the future using all available information. This does not
mean that the forecast is perfectly accurate, but only that it is the best possible given the available
information. This can be written more formally as

𝑒 𝑜𝑓
𝑃𝑡+1 = 𝑃𝑡+1
which in turn implies that the expected return on the security will equal the optimal forecast of the return:

𝑅𝑒 = 𝑅𝑜𝑓
𝑒
Unfortunately, we cannot observe either 𝑅 𝑒 or 𝑃𝑡+1 , so the equations above by themselves do not tell us
much about how the financial market behaves. . However, if we can devise some way to measure the value
of 𝑅 𝑒 , these equations will have important implications for how prices of securities change in financial
markets.

The supply-and-demand analysis of the bond market shows us that the expected return on a security (the
interest rate in the case of the bond examined) will have a tendency to head toward the equilibrium return.
Supply-and-demand analysis enables us to determine the expected return on a security with the following
equilibrium condition: The expected return on a security 𝑹𝒆 equals the equilibrium return 𝑹∗ , which
equates the quantity of the security demanded to the quantity supplied; that is,

𝑅𝑒 = 𝑅∗
It is sufficient to know that we can determine the equilibrium return and thus determine the expected
return with the equilibrium condition. We can derive an equation to describe pricing behavior in an efficient
market by using the equilibrium condition to replace Re with R* in Equation 2. In this way we obtain

𝑅𝑜𝑓 = 𝑅∗
This equation tells us that current prices in a financial market will be set so that the optimal forecast of a
security’s return using all available information equals the security’s equilibrium return. Financial
economists state it more simply: A security’s price fully reflects all available information in an efficient
market.

Rationale Behind the Hypothesis

To see why the efficient market hypothesis makes sense, we make use of the concept of arbitrage, in which
market participants (arbitrageurs) eliminate unexploited profit opportunities, meaning returns on a
security that are larger than what is justified by the characteristics of that security.

Arbitrage is of two types: pure arbitrage, in which the elimination of unexploited profit opportunities
involves no risk, and the type of arbitrage we discuss here, in which the arbitrageur takes on some risk when
eliminating the unexploited profit opportunities.
Another way to state the efficient market condition is this: In an efficient market, all unexploited profit
opportunities will be eliminated.

An extremely important factor in this reasoning is that not everyone in a financial market must be well
informed about a security for its price to be driven to the point at which the efficient market condition
holds.

Financial markets are structured so that many participants can play. As long as a few (who are often
referred to as “smart money”) keep their eyes open for unexploited profit opportunities, they will eliminate
the profit opportunities that appear because in so doing, they make a profit. The efficient market
hypothesis makes sense because it does not require everyone in a market to be cognizant of what is
happening to every security.

Evidence on the Efficient Market Hypothesis

Evidence in Favor of Market Efficiency

Evidence in favor of market efficiency has examined the performance of investment analysts and mutual
funds, whether stock prices reflect publicly available information, the random-walk behavior of stock prices,
and the success of so-called technical analysis.

 Performance of Investment Analysts and Mutual Funds

Many studies shed light on whether investment advisers and mutual funds (some of which charge steep
sales commissions to people who purchase them) beat the market. One common test that has been
performed is to take buy and sell recommendations from a group of advisers or mutual funds and compare
the performance of the resulting selection of stocks with the market as a whole. Sometimes the advisers’
choices have even been compared to a group of stocks chosen by putting a copy of the financial page of the
newspaper on a dartboard and throwing darts.

Consistent with the efficient market hypothesis, mutual funds are also not found to beat the market.
Mutual funds not only do not outperform the market on average, but when they are separated into groups
according to whether they had the highest or lowest profits in a chosen period, the mutual funds that did
well in the first period did not beat the market in the second period.

The conclusion from the study of investment advisers and mutual fund performance is this: Having
performed well in the past does not indicate that an investment adviser or a mutual fund will perform
well in the future.

 Do Stock Prices Reflect Publicly Available Information?

The efficient market hypothesis predicts that stock prices will reflect all publicly available information. Thus,
if information is already publicly available, a positive announcement about a company will not, on average,
raise the price of its stock because this information is already reflected in the stock price. Early empirical
evidence also confirmed this conjecture from the efficient market hypothesis: Favorable earnings
announcements or announcements of stock splits (a division of a share of stock into multiple shares, which
is usually followed by higher earnings) do not, on average, cause stock prices to rise.

 Random-Walk Behavior of Stock Prices

The term random walk describes the movements of a variable whose future changes cannot be predicted
(are random) because, given today’s value, the variable is just as likely to fall as to rise. An important
implication of the efficient market hypothesis is that stock prices should approximately follow a random
walk; that is, future changes in stock prices should, for all practical purposes, be unpredictable. The
random-walk implication of the efficient market hypothesis is the one most commonly mentioned in the
press because it is the most readily comprehensible to the public. In fact, when people mention the
“random-walk theory of stock prices,” they are in reality referring to the efficient market hypothesis.

Financial economists have used two types of tests to explore the hypothesis that stock prices follow a
random walk. In the first, they examine stock market records to see if changes in stock prices are
systematically related to past changes and hence could have been predicted on that basis. The second type
of test examines the data to see if publicly available information other than past stock prices could have
been used to predict changes. These tests are somewhat more stringent because additional information
(money supply growth, government spending, interest rates, corporate profits) might be used to help
forecast stock returns. Early results from both types of tests generally confirmed the efficient market view
that stock prices are not predictable and follow a random walk.

 Technical Analysis
A popular technique used to predict stock prices, called technical analysis, is to study past stock price data
and search for patterns such as trends and regular cycles. Rules for when to buy and sell stocks are then
established on the basis of the patterns that emerge. The efficient market hypothesis suggests that
technical analysis is a waste of time. The simplest way to understand why is to use the random-walk result
derived from the efficient market hypothesis that holds that past stock price data cannot help predict
changes. Therefore, technical analysis, which relies on such data to produce its forecasts, cannot
successfully predict changes in stock prices.

Evidence Against Market Efficiency

In recent years, the theory has begun to show a few cracks, referred to as anomalies, and empirical
evidence indicates that the efficient market hypothesis may not always be generally applicable.

 Small-Firm Effect
Many empirical studies have shown that small firms have earned abnormally high returns over long periods
of time, even when the greater risk for these firms has been taken into account. Various theories have been
developed to explain the small-firm effect, suggesting that it may be due to rebalancing of portfolios by
institutional investors, tax issues, low liquidity of small-firm stocks, large information costs in evaluating
small firms, or an inappropriate measurement of risk for small-firm stocks.
 January Effect
Over long periods of time, stock prices have tended to experience an abnormal price rise from
December to January that is predictable and hence inconsistent with random-walk behavior. This so-
called January effect seems to have diminished in recent years for shares of large companies but still
occurs for shares of small companies. Some financial economists argue that the January effect is due to
tax issues. Investors have an incentive to sell stocks before the end of the year in December because
they can then take capital losses on their tax return and reduce their tax liability. Then when the new
year starts in January, they can repurchase the stocks, driving up their prices and producing abnormally
high returns. Although this explanation seems sensible, it does not explain why institutional investors
such as private pension funds, which are not subject to income taxes, do not take advantage of the
abnormal returns in January and buy stocks in December, thus bidding up their price and eliminating
the abnormal returns.

 Market Overreaction
Recent research suggests that stock prices may overreact to news announcements and that the pricing
errors are corrected only slowly.11 When corporations announce a major change in earnings, say, a
large decline, the stock price may overshoot, and after an initial large decline, it may rise back to more
normal levels over a period of several weeks. This violates the efficient market hypothesis because an
investor could earn abnormally high returns, on average, by buying a stock immediately after a poor
earnings announcement and then selling it after a couple of weeks when it has risen back to normal
levels.

 Excessive Volatility
A closely related phenomenon to market overreaction is that the stock market appears to display
excessive volatility; that is, fluctuations in stock prices may be much greater than is warranted by
fluctuations in their fundamental value.

 Mean Reversion
Some researchers have also found that stock returns display mean reversion: Stocks with low returns
today tend to have high returns in the future, and vice versa. Hence stocks that have done poorly in the
past are more likely to do well in the future because mean reversion indicates that there will be a
predictable positive change in the future price, suggesting that stock prices are not a random walk.
Other researchers have found that mean reversion is not nearly as strong in data after World War II and
so have raised doubts about whether it is currently an important phenomenon. The evidence on mean
reversion remains controversial.
  New Information Is Not Always Immediately Incorporated into Stock Prices
Although it is generally found that stock prices adjust rapidly to new information, as is suggested by the
efficient market hypothesis, recent evidence suggests that, inconsistent with the efficient market
hypothesis, stock prices do not instantaneously adjust to profit announcements. Instead, on average
stock prices continue to rise for some time after the announcement of unexpectedly high profits, and
they continue to fall after surprisingly low profit announcements.

Practical Guide to Investing in the Stock Market

 How Valuable Are Published Reports by Investment Advisers?

The efficient market hypothesis tells us that when purchasing a security, we cannot expect to earn an
abnormally high return, a return greater than the equilibrium return. Information in newspapers and in the
published reports of investment advisers is readily available to many market participants and is already
reflected in market prices. So acting on this information will not yield abnormally high returns, on average.
As we have seen, the empirical evidence for the most part confirms that recommendations from investment
advisers cannot help us outperform the general market.

 Should You Be Skeptical of Hot Tips?

The efficient market hypothesis indicates that you should be skeptical of hot tips since, if the stock
market is efficient, it has already priced the hot tip stock so that its expected return will equal the
equilibrium return. The hot tip is not particularly valuable and will not enable you to earn an abnormally
high return.

 Do Stock Prices Always Rise When There Is Good News?

If you follow the stock market, you might have noticed a puzzling phenomenon: When good news about
a stock, such as a particularly favorable earnings report, is announced, the price of the stock frequently
does not rise. The efficient market hypothesis and the random-walk behavior of stock prices explain this
phenomenon. Because changes in stock prices are unpredictable, when information is announced that
has already been expected by the market, the stock price will remain unchanged. The announcement
does not contain any new information that should lead to a change in stock prices. If this were not the
case and the announcement led to a change in stock prices, it would mean that the change was
predictable. Because that is ruled out in an efficient market, stock prices will respond to
announcements only when the information being announced is new and unexpected. Sometimes a
stock price declines when good news is announced. Although this seems somewhat peculiar, it is
completely consistent with the workings of an efficient market.
  Efficient Markets Prescription for the Investor
What does the efficient market hypothesis recommend for investing in the stock market? It tells us that hot
tips, investment advisers’ published recommendations, and technical analysis—all of which make use of
publicly available information— cannot help an investor outperform the market. Indeed, it indicates that
anyone without better information than other market participants cannot expect to beat the market. So
what is an investor to do?

The efficient market hypothesis leads to the conclusion that such an investor (and almost all of us fit into
this category) should not try to outguess the market by constantly buying and selling securities. This process
does nothing but boost the income of brokers, who earn commissions on each trade. Instead, the investor
should pursue a “buy and hold” strategy—purchase stocks and hold them for long periods of time. This will
lead to the same returns, on average, but the investor’s net profits will be higher because fewer brokerage
commissions will have to be paid.

It is frequently a sensible strategy for a small investor, whose costs of managing a portfolio may be high
relative to its size, to buy into a mutual fund rather than individual stocks. Because the efficient market
hypothesis indicates that no mutual fund can consistently outperform the market, an investor should not
buy into one that has high management fees or that pays sales commissions to brokers but rather should
purchase a no-load (commission-free) mutual fund that has low management fees.