Inefficient Efficient Market Hypothesis


Efficient Market Hypothesis (EMH) very emphatically states that it is impossible to successfully time stock or market swing even after using all information about stocks. The theory of the Efficient Market Hypothesis, developed by Eugene Fama in 1960, is based on the concept that the relevant information and factors that influence stock prices automatically affect stock prices, and therefore it is not possible to ‘beat the market’. EMH (also called random-walk theory) assumes the existence of an efficient stock market, where stocks always trade at fair value. It is not possible either to purchase undervalued stock or to sell stocks at inflated prices. The returns vary with the extent of risk involved, and there is no game of skill involved in dealing with stocks. The chance factor dominates all other influences. Many books, dissertations, journal articles, and manuscripts have been written supporting this theory.

‘But over the last few years, a new school of investing called behavioral finance has become popular with professionals and amateur investors alike and has challenged the foundations of efficient market hypothesis. By carefully studying investor behavior, active money managers can identify profitable clues about what stocks to buy and when’1

The theoretical foundation of EHM is challenged by the finance and stock experts as well as by the economists. The rationalistic market approach of EMH has crumbled under the effects of the more practical theory of ‘Behavioral Finance’. To cement the theory of EMH with demonstrable facts, the adherents of EMH have had to bend it into interesting contortions and grant some very concessions, so large that it almost no longer matters whether the theory exists or not.

Market Efficiency

EMH assumes that large and free stock markets are efficient. The theory works on three basic assumptions investors are a) rational, b) fully and well informed, and c) maximize their expected utility. Another stated consequence of this hypothesis is that stock prices are supposed to move at random, as unexpected relevant information happens at random. Accordingly, there can only be one possible market price as there is no arbitrage opportunity.

The efficient market hypothesis implies that it is not usually possible to outperform the market by using information that the market knows except through luck or with inside information. Market efficiency also means prices allow for the best allocation of resources, a condition that exists only in a situation like perfect competition. This optimum allocation is possible when the market is structured and organized in a way that allows a ‘perfect competition’ that result in a ‘fair price’

‘If EMH is the correct description of price change, a market participant must: 1. Receive relevant information immediately, 2. Properly interpret that information and 3. Act (trade) immediately on that information to maximize their own profits. The first of these isn’t too far fetched. There is always some delay in information flow, but technology is gradually improving this situation. The second and third items here are another story. When new information becomes available, do all market participants properly evaluate that information so that their actions put prices in the “correct” direction? Not likely. Even if market participants are able to properly interpret new information, they still need to act on that information so as to maximize their own profits. This isn’t just unlikely, it’s impossible. Not all traders are willing or able to place trades at all times. Mutual fund managers and institutional traders are limited in how and how often they may trade. Private investors will often ignore information rather than admit that their prior predictions were incorrect. Can the sum of inefficient participant be an efficient market?’2. Thus efficient market, though a prior condition for the success EMH, does not exist in reality; and that is why a question has been imposed on relevance of EMH.

EMH and Behavioral Finance (BF)

According to EMH, stock prices or their future trend cannot be predicted. However, behavioral finance factors play all important and very crucial roles in such decision making of individual investors. Behavioral Finance is simply the study of how psychological biases influence individual’s ability to take financial decisions. The approach of BF, that studies mispricing and its causes, refutes the efficiency market hypothesis. Behavioral analysis admits the existence of only a degree of efficiency that brings some loose relations between the market prices and economic world

‘The theoretical arguments of EMH are:

  1. Investors are assumed to be rational and hence they value securities rationally,
  2. To the extent that some investors are not rational, their trades are random and hence cancel each other without affecting prices, and
  3. To the extent investors are irrational in similar ways; they are met in the market by rational arbitragers who eliminate their influence on prices.’3

Therefore, the rational behavior of the market participants is the crux of the theory of EMH, as the investors who are persistently irrational will be exploited by the rational arbitrageurs and will not remain in the market for long. The fact is otherwise; in reality irrational behavior is the norm. ‘In the late stages of a bull market, the market is driven by buyers who take notice of underlying value. Towards the end of a crash, markets go into free falls as participants extricate themselves from positions regardless of usually good value that their position represent.’4 EMH academician may argue that rational forces will work out the irrationality as a corrective methodology of EMH; but behavioral finance explains that market participants are not driven primarily by whether prices are cheap or expensive but by whether they expect them to rise or fall.

Proponents of behavioral finance insist that in certain key areas the reality is altogether different from what has been envisaged under EMH. The working of EMH assumes an atmosphere like perfect competition and if that is the situation investors should remain indifferent between dividends and capital gains. Rational investor under EMH maneuvering of prices would prefer capital gains to dividend, and also the companies should prefer repurchase to paying dividends. However, in reality companies pay dividend and prices of stocks rise in anticipation of increased dividend. Therefore a prediction about future prices can be made on basis of various measures such as price- earnings, price to book ratios, earning surprises, dividend changes, or share repurchase.

BF postulates that investors have cognitive biases- imperfections in their perceptions of reality. ‘Behavioral Finance has two building blocks: cognitive psychology and the limits to arbitrage. Cognitive refers to how people think. There is a huge psychology literature documenting that people make systematic errors in the way that they think: they are over confident; they put too much weight on recent experiences, etc. Their preferences may also contain distortions. Behavioral Finance uses the body of knowledge, rather than taking the arrogant approach that it should be ignored. Limits to arbitrage refer to predicting in what circumstances arbitrage forces will be effective, and when they won’t be.’5

EMH not a valid theory

The intrinsically non-random character of stock market prices suggests that logical and scientific analyses of the market should only be pursued. EMH (or random walk theory) does not meet the test of practicality as is clear from following observations:

  1. EMH not logical theory: John Allen Paulo in his amusing 2003 book A Mathematician Plays in the Stock Market6 observed that if everyone accepted EMH, then hardly anyone would bother to trade stocks as opposed to just buying or holding them. In addition, if there is hardly any trading, then prices will not be able to reflect all the currently known information. The logic is that practically prices of stocks are more likely to zigzag above and below its correct value and eventually close in on that value. Paulo carried further this logic by stating that the more EMH is not believed, the more likely it is to be true.
  2. Stock prices are set by dollars, not knowledge.:

Take the case of two investors having equal but differing knowledge about market and its forces affecting prices but each possessing vastly different amount of money. In whose directions the stock prices will go? Certainly in favor of investor ready to pay higher price than the other. That means riches dominate the prices despite the fact that both possess similar knowledge about market nuances. There will be a limit to how high a price they are willing to pay, but it will be higher of the two that will fetch the deal. In effect, it is the ‘big money’ and not the ‘smart money’ that dominates the market; and by this virtue, EMH vanishes into thin air.

  1. Positive approach: An investor with negative approach may decide not to take any action. On the other hand, one with a positive outlook can almost always transact for a suitable price. This positive outlook plays a decisive role in raising the prices of stock of say a smaller company. There is no role of EMH under a situation like this. It is a complete behavioral approach adding to decisive market forces.
  2. The economists do not seem to agree to EMH theory as it lacks the basic logic of carrying on a stock transaction. ‘EMH is probably one of the more resilient empirical propositions around, yet it does not seem to have a clearly sound theoretical standing. It all seems to collapse on one particular objection: that if all information is already contained in prices and investors are fully rational, then not only one can not profit from using one’s information, indeed, there might not be any trade at all!’7
  3. There are three forms of EMH, namely, the weak form, the semi- strong form, and the strong form. ‘The weak form of EMH asserts that all past market prices and data are fully reflected in assets prices. The implication of this is that technical analysis cannot be used to beat the market. The semi- strong form of EMH asserts that all publicity available information is fully reflected in asset prices. The implication of this is that technical analysis cannot be used to beat the market.. The strong form of EMH asserts that all information- public or private- is fully reflected in asset prices. The implication of this is that technical analysis cannot be used to beat the market.’8. When a theory does not allow technical analysis in any of its variants under any pretext, the theory loses its character of logical conclusions.
  4. Another hole in the EMH was revealed by publication of studies of price behavior, which discovered that the volatility of price changes among individual securities tends to persist. Stocks which fluctuate, say five to ten percent up or down per week, tend to continue fluctuating with that degree of volatility, while stock volatilities of only one or two percent up or down per week also tend to persist.


Efficient Market Hypothesis (or random walk theory) believes that stock prices have no memory and it is impossible to predict future prices. However, experienced market observers have pointed out that long-term upward trend exist in stock market. Several studies have demonstrated that historical price information can differentiate between positive and negative future price changes, or at least between average and below average returns. So far as security selection is concerned, studies like price/ earning ratios, insider trading activity, and relative strength etc. have proven the EMH theory invalid. The random walk theorists either ignore the evidence when it goes against them or attempt to explain it away. It is for this reason EMH has gained such little respect in the practical investment community. That is why Schleifer is right to state that theoretical foundations as well empirical evidences supporting EMH have been challenged. The challenges are worth relevance in view of inefficient EMH.


Fair Game, Think you can beat the market? Eugene Fama Still Say You Can’t, Research by Eugene Fama, Web.

Are markets Efficient?, 1 Sigma, Web.

Application of Behavioral Finance, Finance and Investment Conference 2004, page 5, Web.

Efficient Market Hypothesis, Trading, Web.

Jay R. Ritter, 2003, Behavioral Finance, Page 2, Web.

John Allen Paulo, 2003, A Mathematician Plays in the Stock Market.

Finance Theory, Web.

Market Efficiencies, February 1999, Web.

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