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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). ...read more.


Futhermore, Rolf Banz uncovered a anomaly in 1981; he found that small firms tend to have higher abnormal returns than do larger firms. Subsequent research indicated that most of the difference in returns between them occurred in the month of January (Clarke, Jandik and Mandelker, p.20). There is no evidence that small stocks are much riskier in January, therefore, since both a company's size and coming of the month of January is information known to the market, the excess returns based on stale information, contrasts the semi strong form efficiency hypothesis. Although no theory is perfect, the is an abundance amount of evidence supporting the EMH, at least in the weak and semi-strong form efficiency. However, the substantial noise that is apparent in the markets have led academic researchers to turn to other theories. 2) Discuss the behavioural challenge to market efficiency. As mentioned, the EMH assumes that decision makers are considered to be rational and utility maximising. However, in reality, there are many instances where emotion and psychology influences peoples decisions, causing unpredictable or irrational behaviour. This had led to the emergence of behavioural finance, which provides reason for some of the anomalies mentioned in part 1 and hence questions the conventional methods of modelling investor behaviour. ...read more.


Moreover, as regret aversion suggests, regret of a bad investment is lower when you know other have make the same mistake. Herding can lead to speculative bubbles, which historically have resulted in stock market crashes. People base their decisions on what the herd does, instead of rigorous analysis. When such psychological biases exist, the market swings on the basis of very little information, which can push stock prices far above their actual worth (Nofsinger 2002, p.80) Challenge to EMH Such psychological behaviors affect the EMH in a number of ways. Moreover, if the theory behind behavioral finance is in fact correct, we can assume a number of possible behavioral patterns within financial markets. These patterns include: an over or under-reaction to price changes or news, extrapolation of past trends for future, lack of attention to fundamentals underlying a stock, target on popular stocks, and seasonal price cycles (Brabazon 2000, p.6).The implications of these patterns provide a basis for investors to exploit pricing anomalies as means of obtaining superior risk adjusted returns, challenging the EMH. On the other hand, Fama argues that prices are just as likely to over-react as they are to over-react (Shleifer 2000, p.47). They are chance events that will balance each other out overall, suggesting that the EMH is still accurate and relevant. Further, these anomalies from irrational behaviour is argued to be met by other rational investors where arbitrage will drive prices back to their ?correct? level. ...read more.

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