Implications and Limitations of the Efficient Market Hypothesis

The limitations of EMH include overconfidence, overreaction, representative bias, and information bias.

Learning Objective

  • Discuss the limitations of the Efficient Market Hypothesis

Key Points

    • Empirical evidence has been mixed, but has generally not supported strong forms of the Efficient Market Hypothesis.
    • Speculative economic bubbles are an obvious anomaly in that the market often appears to be driven by buyers operating on irrational exuberance, who take little notice of underlying value.
    • Any anomalies pertaining to market inefficiencies are the result of a cost benefit analysis made by those willing to incur the cost of acquiring the valuable information in order to trade on it.
    • The financial crisis of 2007–2012 has led to renewed scrutiny and criticism of the hypothesis, claiming that belief in the hypothesis caused financial leaders to adopt a "chronic underestimation of the dangers of asset bubbles breaking".

Terms

  • information bias - Information bias is a type of cognitive bias, and involves distorted evaluation of information. Information bias occurs due to people's curiosity and confusion of goals when trying to choose a course of action.
  • efficient markets hypothesis - a set of theories about what information is reflected in securities trading prices

Investors and researchers have disputed the Efficient Market Hypothesis both empirically and theoretically. Behavioral economists attribute the imperfections in financial markets to a combination of cognitive biases such as overconfidence, overreaction, representative bias, information bias, and various other predictable human errors in reasoning and information processing. These have been researched by psychologists such as Daniel Kahneman, Amos Tversky, Richard Thaler, and Paul Slovic. These errors in reasoning lead most investors to avoid value stocks and buy growth stocks at expensive prices, which allow those who reason correctly to profit from bargains in neglected value stocks and the excessive selling of growth stocks.

Empirical evidence has been mixed, but has generally not supported strong forms of the Efficient Market Hypothesis. According to a publication by Dreman and Berry from 1995, low P/E stocks have greater returns. In an earlier paper Dreman also refuted the assertion by Ray Ball that these higher returns could be attributed to higher beta. Ball's research had been accepted by Efficient Market theorists as explaining the anomaly in neat accordance with modern portfolio theory.