Market Efficiency: The proposition that securities markets are efficient forms the basis for most research in financial economics. Is this statement supported in the economic literature?

Since Keynes’ (1936) made his famous pronouncement that most investors’ decisions "can only be taken as a result of animal spirits-of a spontaneous urge to action rather than inaction, and not as the outcome of a weighted average of benefits multiplied by quantitative probabilities," a great deal of research has been devoted to examining the efficiency of stock market price formation. In this paper I will explore the random walk theory, or the Efficient Market Hypothesis, shedding new light on this much-disputed topic. There have been several recent papers, which have uncovered empirical evidence that suggests that stock returns contain predictable components. For example, Leim and Stambaugh (1986) find statistically significant predictability in stock prices by using forecasts based on certain predetermined variables. This provides a plausible explanation for the trend towards randomness in the recent data, one that stems back to Samuelson’s "Proof that Properly Anticipated Prices Fluctuate Randomly." Market opportunities need not be market inefficiencies, but in my opinion it would be preposterous to assume that the market is fully efficient. Certainly, we do not live in a frictionless world, and at best I can only assume that the market is semi-efficient!

I have rejected the random walk hypothesis for weekly stock market returns supported by a simple volatility-based specification test conducted by Andrew W. Lo and Criag MacKinlay. These rejections can be explained completely by infrequent trading, time lags, or time-varying volatilities. The rejection of the random walk hypothesis does not necessarily imply the inefficiency of stock-price formation, but rather that there are so called glitches in the system which an intelligent investor can manipulate, producing uncharacteristic returns.

A trading market is one in which the current price reflects all available information from past prices and volumes. In such a market, past price and volume patterns cannot provide meaningful predictions of future price movements. Theoretically this is a true statement, but in practice things work a little differently. These minimum features describe a weak form efficient market. More stringent requirements describe semi-strong and strong forms of the market.

Efficiency is often categorized by the strength of the efficiency that can be proven. For example, in the weak form there are no dependencies in past price changes that a technician could use to predict future changes, which is the foundation for the theory that prices are simply a random walk. In the semi-strong form the current price reflects all publicly available information that might affect the price. Now, in the strong form the current price reflects all relevant information, whether publicly available or not, which is referred to as "Market Efficiency." An economic model of the market suggests that both demand and supply work together to determine the price at, which the good trades and the quantity traded. Therefore, in informationally efficient markets, prices must be unforecastable if they are properly anticipated, fully incorporating the expectations and information of all market participants.

The securities Market Line of the Capital Asset Pricing Model (CAPM) is frequently used as an asset valuation model describing the relationship between expected risk and expected return for marketable assets. The CAPM posits that the intercept of a regression equation between an asset's returns and the returns of systematic factors equal 0% in an efficient market, but it does not necessarily assume a single source of systematic risk. Systematic Risk is risk that is associated with the movement of a market or market segment as opposed to distinct elements of risk associated with a specific security. Systematic risk cannot be diversified away; it can only be hedged. Within the context of the Capital Asset Pricing Model (CAPM), exposure to systematic risk is measured by Beta. On the other hand, non-Systematic Risk is an element of price risk that can be largely eliminated by diversification within an asset class. In factor models estimated by regression analysis, it is equal to the standard error. This is also referred to as the Security Specific Risk, or Idiosyncratic Risk.

Diversification is simply the impact of certain number of securities held on risk level of particular Portfolio. This is an approach to investment management analysed and popularised by Harry Markowitz and encouraged by widespread acceptance of the usefulness of the capital asset pricing model (CAPM). With diversification, risk can be reduced relative to the average return of a portfolio by distributing assets among a variety of asset classes such as stocks, bonds, money market instruments, and physical commodities, as well as by diversifying within these categories and across international boundaries. Diversification usually reduces portfolio risk (measured by return variability) because the returns (both positive and negative) on various asset classes are not perfectly correlated. Although this classic model embodied in the security market line is not always empirically affirmed, it is the most widely used approach to relative asset evaluation. Another popular method is "The Modern Portfolio Theory" (MPT) is a variety of portfolio construction, asset valuation, and risk measurement concepts and models that rely on the application of statistical and quantitative techniques. Among the concepts and models associated with MPT are: portfolio theory, the capital asset pricing model (CAPM), arbitrage pricing theory, and the Black-Scholes option pricing model. We mustn’t forget that although diversification is an important strategy, you can limit your returns by diversifying too much, which is a small price to pay for the risk-averse investor.

This also leads us to the E-V Maxim, which was also a proposition that was first put forth by Harry Markowitz. It asserts that an investor should choose the portfolio that offers the highest expected return for a given level of variance. Quite an obvious concept, but it was the famous economist Milton Friedman who rejected Markowitz’s theory at the University of Chicago claiming that it was not economics, nor could he be awarded his P.H.D for research not fundamentally based in economics. Not only did Markowitz receive his P.H.D., but he also won a nobel prize for his theory, which is now one of the critical foundations for the financial sectors.

So what exactly is the purest market? Financial markets join investors with entrepreneurs allowing firms to obtain equity and debt. The overall purpose of financial markets is to provide capital to the real economy. Commercial banks are a key part of our monetary system. Banks accept deposits and make loans, which are heavily regulated to prevent people from loosing their life savings because of misjudgement or corruption of a particular bank, potentially causing a run on the banking system. These superior forms of capitalism are regulated by a system that: defines property rights, mandates forms of disclosure, and prohibits certain types of transactions (insider trading), attempting to prevent inefficiency. Unfortunately these regulations are not perfect, and rules tend to be broken leading to a glitch in the so-called "efficient market." Indeed this provides an opportunity for those few who are skilled enough (not lucky) to take advantage of these glitches in the market, and produce phenomenal returns.

What exactly is the relationship between the financial economy and the real economy? In some instances financial markets are poor at predicting profitability of an enterprise over the long run. Stock prices are based on information and it is not important whether that information accurately reflects the underlying reality. Various market advocates argue that financial markets reorganize assets and that any interference with how the market organizes assets reduces the allocation of efficiency. However, the process of reorganizing financial assets may not guarantee high growth and full employment (Keynesian Efficiency) or technical advance (Dynamic Efficiency). Money markets often sacrifice long-term investment for short-term windfall. At this juncture the question that should be asked is weather or not hostile takeovers and leveraged buyouts should be encouraged to hold management accountable or discouraged as speculative capitalism? Should banks and thrift institutions be allowed to merge and pursue non-banking business? Taken to the extreme the market’s short-term pursuit of profit can be ruinous. Some have suggested more favourable treatment of these practices for long-term investments. Market advocates say this favourable treatment impedes normal shifting of capital assets reducing efficiency.

The efficient market hypothesis says that the stock market knows everything about the value of a company that can be known. All of this information is rapidly diffused and embodied in the market’s pricing of a stock. The problem is when the stock market crashes there are no changes in the underlying value of assets. Either the market was wrong before the crash or after the crash. Many economists feel that a trading market is a zero sum game. What one person gains another loses. The market diverts dollars that would have otherwise been spent in the real economy, and most of the stock market is a secondary market. Efficient market theory says stock prices are rational and substantially random. From this comes the assumption that ideally you can’t beat the market. The only reply I have to that is, certainly for one individual to win another has to lose. If everyone wins, in reality we all lose, the fundamental difference between a capitalist market and a socialist based economy.

We must also consider the simple fact that mutual funds, which are publicly traded, tend to diverge from the value of the underlying stocks. This should not happen if markets are efficient. The "Great Crash" of 1929’ demonstrated the multiple failures of unregulated financial markets to self-correct. Too much government intervention and control puts a halt on the forces of supply & demand, eliminating a free-market, but no government intervention could prove to be disastrous, as history has proven to us before.

Without a doubt in my mind I believe that the financial markets are predictable to some degree. The random walk hypothesis is a variant of the efficient market hypothesis. It holds that stock prices follow a random walk pattern and, consequently, historic prices are of no value in forecasting future prices. Unlike the many applications of the Random Walk Hypothesis in the natural and physical sciences in which randomness is assumed almost by default, because of the absence of any natural alternatives, Samuelson argues that randomness is achieved through the active participation of many investors seeking greater wealth. Unable to curtail their greed, an army of investors aggressively pounce on even the smallest informational advantages at their disposal, and in doing so, they incorporate their information into market prices and quickly eliminate the profit opportunities that gave rise to their aggression. If this occurs instantaneously, which it must in an idealized world of "frictionless" markets and costless trading, then prices must always fully reflect all available information and profits can be garnered from information-based trading (because such profits have already been captured). This has a wonderfully counter-intuitive and seemingly contradictory flavour to it: the more efficient the market, the more random the sequence of price changes generated by such a market. Thus, the most efficient market of all is one in which price changes are completely random and unpredictable.

A study conducted by LeRoy (1973) and Lucas (1978), who construct explicit examples of informationally efficient markets where prices do not follow the "Random Walk Hypothesis." Backed up by the evidence of Grossman (1976) and Stiglitz (1980) I must argue that efficient markets are impossibility because if markets were perfectly efficient then the return on gathering information would be nil. Therefore, there would be absolutely little or no reason to trade. Alternatively, the degree of market inefficiency determines the effort investors are willing to expend to gather and trade on that information, thus a market equilibrium would only arise if there are sufficient profit opportunities, basically inefficiencies which compensate investors for the costs of trading and information gathering.

I believe that from a practical point of view the Efficient Market Hypothesis is an idealization that is economically unrealisable, but serves as a useful benchmark for measuring relative efficiency. Despite the occasional "excess" profit opportunity, on average and over time, it is impossible to earn such profits consistently without some type of competitive advantage. With superior information, superior technology, financial innovation you can develop methods to beat the "efficient market" to earn positive profits consistently. This opens the door to superior long-term investment returns through disciplined active investment management. Unlike the experimental sciences such as physics or biology, financial economics relies primarily on statistical inference to test its theories. Therefore, we can never know with perfect certainty that a particular investment strategy is successful since even in the most profitable strategy it can always be argued that it’s simply "luck." Ultimately there have been an will be those elite few who find their niche in the market, and exploit it to gain extraordinary returns, innovating and producing more arguments about the "Efficient Market Hypothesis", for economists and academics to squabble over!