Introduction
The main reason for investing in the financial markets is for capital gains. This is the return on investment which arises due to the price differences of the securities in the financial market. The investors buy and sell shares in the stock exchange market hoping to make a gain. They will buy the securities when the security price are low and sell them when the prices increase. The gain due to the differences in price is known as the capital gain. However, investors require having full information regarding the company operations before buying the company securities.There is a positive correlation between the worth of the securities and the performance of a company. In 1970, Eugene Fama argued that the security prices in the capital market should reflect the available information in the market. His argument was known as an efficient market analysis(Carlos Correia, 2012, pp. 4-27).
The paper will discuss the propositions suggested by Eugene Fama in an efficient financial market. He came up with various efficient market hypotheses. The hypothesis helps in explaining the allocative efficiency in the financial markets(Krishnamurti, 2009, p. 6).
Forms of market efficiency
Market efficiency can be defined as the extent to which the prices of the securities in the financial market reflect the information available to investors.Fama argues that the price of the security should reflect the information available regarding the securities. The securities include shares, debentures and loans. Eugene Fama developed three main forms of market efficiency namely the weak form efficiency, semi-strong form efficiency and the strong form efficiency(Scott Besley, 2008, p. 758).
The weak form efficiency argues that the current share of the shares in the financial market reflects all the past information about the shares. The price of the securities is based on the past information of their prices. Therefore, it is difficult to predict future prices of the shares. The historical prices of the shares are irrelevant in making future decisions. Additionally, the historical share prices do not have any influence on the future performance of the shares. The share prices acts in a random manner in this kind of market system. The information available to the public does not have any effect on the price of the shares. The investor should develop trading strategies in order to maximize on the capital gains(Schubert, 2009, p. 1).
The semi-strong form efficiency hypothesis states that the current prices of the securities show the historical prices of the shares and the information available to the public. Unlike in the weak form efficiency, the semi strong form efficiency takes into consideration not only the historical prices, but also the information available to the public. Returns to the investor will be determined by any information released to the public regarding the performance of the business. An investor can make abnormal returns from the information released into the market. Any public announcement will cause some reactions on the market prices of the securities.In this case, investors with additional information regarding the performance of the company are likely to make higher returns than investors with little or no information.
The strong form efficiencyhypothesis states that the security prices in the financial market reflect the information available to the public. The investors are aware of both inside and outside information regarding the company performance. In such a case, no investor will make abnormal returns. All investors have the same type of information. An investor requires making appropriate trading strategies in order to make abnormal returns. Access to insider information about the company does not give an investor additional advantage in making higher profits than the others. All the information that is important in decision making is available to all investors.
The evidence for and against the theory that the stock market share prices fully and fairly reflect known information
The efficient market hypothesis proposes that the current securities price reflect the publicly available information about the value of the company. The market hypothesis is also known as the random walk theory. According to the theory, there are no chances of earning excess profits in the financial markets by using the publicly available information. The main issue addresses in the theory is why there are changes in the security prices in the financial market and how the changes takes place. According to Fama, high competition leads to disclosure of new information in the market. The new information will have an impact on the actual prices of the securities.
Evidence in favor of the different forms of efficient market hypotheses
1. The weak form efficiency
According to the random walk hypotheses, also known as the weak form efficiency, the security’s price movements should be independent of each other. Previous studies show that there is a tendency of correlation between the current returns from a particular security and future returns from the security. Positive correlation between the returns implies there is tendency for the continuation. The returns from a security will continue providing higher returns than previously. Negative correlation between the returns will tend to show a reversal. High returns from a security are followed by low returns from the same security.
For the random walk hypotheses to be true there should be no correlation between the present and future returns from the securities. Eugene Fama concluded that the correlation coefficients were too littleto cover the transaction costs of trading. Even though the correlation coefficients were statistically significant, there would still be zero correlation between the past and future returns. Brock and LeBaron (1992) concluded that simple technical trading rules do not have a significant impact in predicting the future security prices(M. Ishaq Bhatti, 2006, p. 233).
2. The semi strong form efficiency
The security’s price reflects the new available information in the market. The market efficiency theory states that the security prices replicate all the widelyexisting information about the business. Therefore, the investors will have inconsistent gains due to the publicly available information. Many people think that mutual fund managers are examples of skilled investors who are able to outperform the rest of the investors in the market. The financial market participants will respond immediately in case there is new information released into the market. The participants also act in an unbiased manner.
Additional evidence in support of the semi strong market efficient would be the relationship between the security price and the stock split. Stock split involves increasing the number of company shares by reducing their par value. Conventionally, a stock split is evidence that the company is performing well. This implies that the security price will increase upon stock split. This will lead to an increase in the amount of dividends paid. Therefore, investors will buy the company securities. Studies carried out by Eugene Fama, Michael Jensen and Richard Roll found out that there are no incidences of abnormal stock performance even after the stock split.The investors will not gain by purchasing the shares during the split date(R. Charles Moyer, 2008, p. 42).
The securities performance of the target companies tends to decline after the takeover announcement has been made. Prior to the announcement, the securities will be trading at the normal prices. However, after the announcement, the security prices will tend to decline. The investors will not be interested in buying the shares. This provides evidence of the semi strong efficient hypotheses.
3. The strong form efficiency hypotheses
An investor cannot make abnormal returns from having access to internal and external company performance. In such a case, an investor cannot make abnormal returns from the information that is available to all other investors. An investor ought to have some extra information regarding the company performance. Insider trading has been found to be profitable(Barnes, 2010, p. 47).
Evidence against the three forms of market hypotheses
Michael Price, a legendary portfolio manager, argues that markets are imperfectly efficient. This implies that there is no relationship between the information available and the price of the company securities. Efficient market hypothesis has been criticized by various investment professionals.
Over reaction and under reaction is one of the main weaknesses against the different forms of the market efficient hypotheses. The hypotheses imply that investors will react immediately and quickly to any new information released into the market. In addition, the investors act in an unbiased manner. Therefore, securities with low past returns will have high returns in the future. Alternatively, stocks with high past returns will tend to have high future returns. However, the security’s price tends to adjust depending on the annual earnings of a company are announced. The security prices will increase in case the company reports positive earnings. On the other hand, the price will decrease in case the company reports negative earnings. Therefore, securities with high past returns are likely to remain high in the future. This is inconsistent with the efficient market hypothesis theory(Marquardt, 2010, p. 24).
The Small Firm Effect helps to point out the arguments against the theory of market efficient. The effect is also known as the January Effect. From the previous research carried out, majority of the differences between the small and large securities in the financial market occurred in January. Economists argue that the average returns on small securities could not be justified by the Capital Asset Pricing Model (CAPM). The returns were too large to be explained by CAPM method. Most of the predictable securities price movements’ and patterns in the financial market took place in January. The random walk hypotheses suggest that the price movements depend on the available information in the market.
Implications of the random walk theory on investors
Active management strategies by investors have little impact on their returns. This is because the financial markets are highly efficient. The returns will depend on the information available rather than the trading strategies adopted. Any attempt by investors to use management strategies will lead to an increase in costs(Harder, 2010, p. 6).
The investors can only maximize their returns through portfolio diversification and management. Additionally, optimization of returns can be through reduction of investment costs and taxes. The investor should choose on the most appropriate securities. The securities will help to minimize the risk associated with reduction in value of the securities. Therefore, appropriate investment strategy is the best option to increase the returns.
Conclusion
Efficient market hypothesis plays a very crucial role in determining the value of the company securities. There tends to be a relationship between the publicly information available and the value of the securities. However, there are other factors that determine the value of the securities. Minimization of risk in the financial market can be through portfolio management. This involves investing in different types of securities. The securities have different returns thereby minimizing risk(Steven L. Emanuel, 2009, p. 256).
References
Barnes, P. (2010). Stock Market Efficiency Insider Dealing and Market Abuse. New York: Gower Publishing, Ltd.
Carlos Correia, D. F. (2012). Financial Management. Cape Town: Juta and Company Ltd.
Harder, S. (2010). The Efficient Market Hypothesis and Its Application to Stock Markets. Norderstedt: GRIN Verlag.
Krishnamurti, C. (2009). Investment Management: A Modern Guide to Security Analysis and Stock Selection. New York: Springer.
M. Ishaq Bhatti, H. A.-S. (2006). Econometric Analysis of Model Selection And Model Testing. Farnham: Ashgate Publishing, Ltd.
Marquardt, M. (2010). Why are Theoretically Perfect and Efficient Capital Markets So Imperfect and Volatile in Practice?
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R. Charles Moyer, J. R. (2008). Contemporary Financial Management. South Melbourne: Cengage Learning.
Schubert, B. (2009). Weak Form Efficiency Tests. Norderstedt: GRIN Verlag.
Scott Besley, E. F. (2008). Principles of Finance. South Melbourne: Cengage Learning.
Steven L. Emanuel, L. E. (2009). Corporations. New York: Aspen Publishers Online.
