Page 216 - DCOM504_SECURITY_ANALYSIS_AND_PORTFOLIO_MANAGEMENT

Unit 7: Efficient Market Theory

While impressive theoretically, modern portfolio theory has drawn severe criticism from Notes
many quarters. The principle objection is with the concept of Beta; while it is possible to
measure the historical Beta for an investment, it is not possible to know what its Beta will
be going forward. Without that knowledge, it is in fact impossible to build a theoretically
perfect portfolio. This objection has been strengthened by numerous studies showing that
portfolios constructed according to the theory don’t have lower risks than other types of
portfolios.
Modern portfolio theory also assumes that it is possible to select investments whose
performance is independent of other investments in the portfolio. Market historians have
shown that there are no such instruments; in times of market stress, seemingly independent
investments do, in fact, act as if they are related.

7.6 Forms of the Efficient Market Hypothesis

Tests of the market efficiency are essentially tests of whether the three general types of
information—past prices, other public information and inside information – can be used to
make above-average returns on investments. In an efficient market, it is impossible to make
above-average return regardless of the information available, unless abnormal risk is taken.
Moreover, no investor or group of investors can consistently outperform other investors in such
a market. These tests of market efficiency have also been termed as weak-form (price information),
semi-strong form (other public information) and strong-form (inside information) tests.

Weak-form and the Random Walk

This is the oldest statement of the hypothesis. It holds that present stock market prices reflect all
known information with respect to past stock prices, trends, and volumes. Thus it is asserted,
such past data cannot be used to predict future stock prices. Thus, if a sequence of closing prices
for successive days for XYZ stock has been 43, 44, 45, 46, 47, it may seen that tomorrow’s closing
price is more likely to be 48 than 46, but this is not so. The price of 47 fully reflects whatever
information is implied by or contained in the price sequence preceding it. In other words, the
stock prices approximate a random walk. (That is why sometimes the terms Random Walk
Hypothesis and Efficient Market Hypothesis are used interchangeably). As time passes, prices
wander or walk more or less randomly across the charts. Since the walk is random, a knowledge
of past price changes does nothing to inform the analyst about whether the price tomorrow, next
week, or next year will be higher or lower than today’s price.
The weak form of the EMH is summed up in the words of the pseudonymous ‘Adam Smith’,
author of The Money Game: “prices have no memory, and yesterday has nothing to do with
tomorrow.” It is an important property of such a market, so that one might do as well flipping
a coin as spending time analyzing past price movements or patterns of past price levels.

Thus, if the random walk hypothesis is empirically confirmed, we may assert that the stock
market is weak-form efficient. In this case any work done by chartists based on past price
patterns is worthless.
Random walk theorists usually take as their starting point the model of a perfect securities
market in which a relatively large number of investors, traders, and speculators compete in an
attempt to predict the course of future prices. Moreover, it is further assumed that current
information relevant to the decision-making process is readily available to all at little or no
cost. If we ‘idealize’ these conditions and assume that the market is perfectly competitive, then
equity prices at any given point of time would reflect the market’s evaluation of all currently
available information that becomes known. And unless the new information is distributed over
time in a non-random fashion – and we have no reason to presume this – price movements in a

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