Some Common Misconceptions about the EMH

No other idea in finance has attracted as much attention as that of efficient markets, and not all of the attention has been flattering. Rather than rehash the arguments here, we will be content to observe that some markets are more efficient than others. For example, financial markets on the whole are probably much more efficient than real asset markets.

Having said this, however, we can also say that much of the criticism of the EMH is misguided because it is based on a misunderstanding of what the hypothesis says and what it doesn't say. For example, when the notion of market efficiency was first publicized and debated in the popular financial press, it was often characterized by words to the effect that "throwing darts at the financial page will produce a portfolio that can be expected to do as well as any managed by professional security analysts."5

Confusion over statements of this sort has often led to a failure to understand the implications of market efficiency. For example, sometimes it is wrongly argued that market efficiency means that it doesn't matter how you invest your money because the efficiency of the market will protect you from making a mistake. However, a random dart thrower might wind up with all of the darts sticking into one or two high-risk stocks that deal in genetic engineering. Would you really want all of your money in two such stocks?

4The idea behind the EMH can be illustrated by the following short story: A student was walking down the hall with her finance professor when they both saw a $20 bill on the ground. As the student bent down to pick it up, the professor shook his head slowly and, with a look of disappointment on his face, said patiently to the student, "Don't bother. If it were really there, someone else would have picked it up already." The moral of the story reflects the logic of the efficient markets hypothesis: if you think you have found a pattern in stock prices or a simple device for picking winners, you probably have not.

5B. G. Malkiel, A Random Walk Down Wall Street, 2nd college ed. (New York: Norton, 1981).

Ross et al.: Fundamentals of Corporate Finance, Sixth Edition, Alternate Edition

V. Risk and Return

12. Some Lessons from Capital Market History

© The McGraw-Hill Companies, 2002

Richard Roll on Market Efficiency

The concept of an efficient market is a special application of the "no free lunch" principle. In an efficient financial market, costless trading policies will not generate "excess" returns. After adjusting for the riskiness of the policy, the trader's return will be no larger than the return of a randomly selected portfolio, at least on average.

This is often thought to imply something about the amount of "information" reflected in asset prices. However, it really doesn't mean that prices reflect all information nor even that they reflect publicly available information. Instead, it means that the connection between unreflected information and prices is too subtle and tenuous to be easily or costlessly detected.

Relevant information is difficult and expensive to uncover and evaluate. Thus, if costless trading policies are ineffective, there must exist some traders who make a living by "beating the market." They cover their costs (including the opportunity cost of their time) by trading. The existence of such traders is actually a necessary

© The McGraw-Hill Companies, 2002

precondition for markets to become efficient. Without such professional traders, prices would fail to reflect everything that is cheap and easy to evaluate.

Efficient market prices should approximate a random walk, meaning that they will appear to fluctuate more or less randomly. Prices can fluctuate nonrandomly to the extent that their departure from randomness is expensive to discern. Also, observed price series can depart from apparent randomness due to changes in preferences and expectations, but this is really a technicality and does not imply a free lunch relative to current investor sentiments.

Richard Roll is Allstate Professor of Finance at UCLA. He is a preeminent financial researcher, and he has written extensively in almost every area of modern finance. He is particularly well known for his insightful analyses and great creativity in understanding empirical phenomena.

A contest run by The Wall Street Journal provides a good example of the controversy surrounding market efficiency. Each month, the Journal asks four professional money managers to pick one stock each. At the same time, it throws four darts at the stock page to select a comparison group. In the 133 five-and-one-half-month contests from July 1990 to July 2001, the pros won 82 times. However, when the returns on the portfolios are compared to the Dow-Jones Industrial Average, the score is only 70 to 63 in favor of the pros.

The fact that the pros are ahead of the darts by 82 to 51 suggests that markets are not efficient. Or does it? One problem is that the darts naturally tend to select stocks of average risk. The pros, however, are playing to win and tend to select riskier stocks, or so it is argued. If this is true, then, on average, we expect the pros to win. Furthermore, the pros' picks are announced to the public at the start. This publicity may boost the prices of the shares involved somewhat, leading to a partially self-fulfilling prophecy. Perhaps the Journal will change the rules in the future and announce the picks only after the fact.

More than anything else, what efficiency implies is that the price a firm will obtain when it sells a share of its stock is a "fair" price in the sense that it reflects the value of that stock given the information available about the firm. Shareholders do not have to worry that they are paying too much for a stock with a low dividend or some other sort of characteristic because the market has already incorporated that characteristic into the price. We sometimes say that the information has been "priced out."

The concept of efficient markets can be explained further by replying to a frequent objection. It is sometimes argued that the market cannot be efficient because stock prices fluctuate from day to day. If the prices are right, the argument goes, then why do they change so much and so often? From our discussion of the market, we can see that these price movements are in no way inconsistent with efficiency. Investors are bombarded

CHAPTER 12 Some Lessons from Capital Market History 407

with information every day. The fact that prices fluctuate is, at least in part, a reflection of that information flow. In fact, the absence of price movements in a world that changes as rapidly as ours would suggest inefficiency.

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Responses

  • pamphila t
    WHAT IS EMH MISCONCEPTION?
    7 years ago
  • kaija
    What are the misconception or anomalies in the EMH?
    6 years ago

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