I think, therefore I blog

Efficient Market or Predictable Patterns?

By , 25 November 2014

Efficient Market or Predictable Patterns?
Efficient Market or Predictable Patterns?

I'm doing Yale's "Financial Markets" course on Coursera at the moment and for one of the assignments we had to review a paper by Eugene Fama defending his theory of efficient markets. It was kind of interesting, so I wanted to post my summary here for you guys...

In "Market efficiency, long-term returns, and behavioral finance", Eugene Fama reports that anomalies which appear to contradict the Efficient Market Hypothesis are in fact predicted by the hypothesis itself. The hypothesis is therefore not falsified by the observation of these anomalies.

Fama discusses several patterns that have been published and seem to reflect an inefficient market:

  • Past winners tend to be future losers and visa versa (DeBondt and Thaler, 1985)
  • Long term returns are poor on IPOs and seasoned equity offerings (Ritter, 1991; Lougran and Ritter, 1995)
  • Stocks with high returns over the past year tend to have high returns over the following three to six months (Jagadeesh and Titman, 1993)
  • Divesting firms post above-average returns
  • Firms doing a stock-split post above-average returns.
Efficient Market or Predictable Patterns?

He notes that although alternatives to the efficient market model such as the BSV and DHS behavioural models can be used to explain individual trends, they are unable to explain all the trends satifactorily.

Fama argues that despite the presence of the above trends they do not bias either positive or negative returns, hence the expected deviation due to abnormalies is zero as predicted by efficient market hypothesis. He also explains how some of the above results can be the result of rational pricing. E.g. mean-regression may a reaction caused by an exaggerated risk-premium for winners and losers - a rational strategy producing an observable 'anomaly'.

When considering an individual long-term return anomaly there are several possible explanations for its existence:

  1. It is statistically normal and simply the result of chance.
  2. It is the result of poor methodology to determine expected normal returns.
  3. It is a statistical fluke.
  4. It is caused by an inefficient market.

Fama finds thats 1, 2 and 3 account for enough of the anomalies to conclude that the market is in fact efficient, although he does not claim that his hypothesis models perfectly models the market.

Finally Fama discusses the problem of determining a firm's expected return such that anomalies can be accurately identified. There are several problems:

  • Expected return determined relative to market return ignores events specific to the firm.
  • Expected return determined internally ignores events systematic to the whole market.
  • CAPM doesn't accurately describe expected return for small stocks (Banz, 1981)
  • Averaging compounded returns using different methods (AAR, CAR, BHAR) opens the data up to significant misinterpretation.
  • When measured differently abnormal returns may appear normal.

Although Fama does not directly reject the possibility of predictable patterns appearing in the market, he does dispute the conclusion that their existence invalidates Efficent Market Hypothesis.


About Roger Keays

Efficient Market or Predictable Patterns?

Roger Keays is an artist, an engineer, and a student of life. Since he left Australia in 2009, he has been living as a digital nomad in over 40 different countries around the world. Roger is addicted to surfing. His other interests are music, psychology, languages, and finding good food. Click here to subscribe to his weekly blog, or stalk him on Facebook and Twitter.

Join Over 1000 Subscribers

I write every Sunday about travel, psychology, and technology. Thousands of people just like you have already subscribed—and for good reason. It'll change your life. And it's free :)

Read a Good Book

“A spellbinding true story of love, passion and adventure. One can’t help but be swept away by 100% Love Guaranteed.” —Dr Tammie Matson, author of Elephant Dance.

Chat For A While

Your Vote Matters

Which animal will take over when humans go extinct?