Discuss the empirical evidence supportive of and against market efficiency.

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1) Discuss the empirical evidence supportive of and against market efficiency.

The efficient market hypothesis (EMH) predicts that market prices should incorporate all available information at any point in time (Clarke, Jandik and Mandelker, p.9). A market is seen as efficient if it incorporates all new information in its security prices in a rapid and unbiased manner, meaning investors should not be able to systematically outperform the market.

Different kinds of information influence the security values. Hence, there are three versions of the EMH depending on the information assumed to be impounded in prices.

weak form: share prices fully reflect the information implied by all prior price movement (Clarke, Jandik and Mandelker, p.10).

semi strong form: share prices respond instantaneously without bias to newly published information. (Clarke, Jandik and Mandelker, p.10).

strong form: eshare prices fully reflect not only published information but all relevant information including data not yet publicly available.(Clarke, Jandik and Mandelker, p.10).

Since the introduction of the EMH, extensive empirical research has been done towards the EMH, with evidence both for and against it.

Evidence in favour of the EMH

Tests of weak form efficiency originate from the random walk theory, which implies that successive price movements should be independent; future stock prices cannot be predicted based on past stock prices (Clarke, Jandik and Mandelker, p.12). Studies of Kendall, Alexander and Morgenstern to name a few, found no evidence of serial correlation between the current return on a security and the return on the same security over a previous period that were large enough to cover the transaction costs of trading (Keane 1983, p.35). Hence, they follow random walks and are consistent with the weak form efficiency.


Studies of semi-strong form efficiency are done through event studies, where important news events are evaluated to see the effects of these news events on share prices. A study by Keown and Pinkerton (1981) measured the cumulative average returns of 194 takeover targets prior and after the announcement of takeover bid. The results showed that share prices of targets rose prior to the announcement as possible news of the bid was incorporated into prices, and then on the date of public announcement, jumped to fully reflect the takeover premium offered (Shleifer 2000, p.7). There was no continuation in trend up or reversal down post announcement, indicating an instantaneous adjustment of prices to the news, consistent with the semi strong form EMH (Shleifer 2000, p.7).         

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Other event studies including, mergers and acquisitions, seasoned equity offerings, dividend announcements, etc... have generally shown similar results, meaning abnormal returns cannot be expected by trading on the announcement date.


Another study by Michael Jensen, found that over the period 1955 to 1964 mutual funds on average achieved a risk-adjusted performance of approximately zero percent per year; the funds on average were unable to outperform a passive strategy (Keane 1983, p.43). The inability of fund managers to outperform the market, implies that the market is efficient in at least the weak and semi-strong levels, but because there is ...

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