Implications of the Efficient Market Hypothesis for Investors
The question for investors is, “How efficient is the market?” If the
market is truly efficient, no information will be of any use to you,
not even monopolistic information. In this case, the only way
you can beat the markets is to become clairvoyant! However,
the studies cited herein show that the market is not absolutely efficient
because investors have in some cases beaten the market
If investment strategies can beat the market averages consistently
over long periods, the markets are inefficient. The next
question is, “What is the degree of the market’s inefficiency?” If
you start with the extremes of the theory as shown in Figure 12–2,
you can then move back to the center of the argument with the
more debatable aspects of the degrees of inefficiency.
Degrees of Efficiency of Information in the Stock Market
If the market is totally inefficient, all information is useful.
You know that the market is not totally inefficient because none of
the analysts and investors who analyze information has been
able to consistently earn returns in excess of the market averages.
Thus the question remains about how efficient the market is in
processing information between the extremes of all and none,
namely, historical, public, and private information.
If you are averse to number crunching, you can heave a sigh
of relief from saving all those hours spent analyzing financial statements
to determine numbers on sales, earnings, and growth figures
of a company. Similarly, you do not have to waste the gas in your
car to go out to buy graph paper in order to plot stock charts.
According to the weak and semistrong forms of the efficient
market hypothesis, the use of technical and fundamental analysis
does not consistently produce superior returns. This statement
may be disconcerting to you, but what about the technical and
fundamental analysts whose occupations have been deemed to
be worthless? It is no wonder that Wall Street has not embraced the
efficient market hypothesis.
The two seemingly sure ways to earn returns in excess of
the market returns are to obtain insider information and to become
a specialist. This statement is not by any means a suggestion to
prompt you to gain access to corporate privileged information,
and neither should you change your existing professional occupational
plans to become a New York Stock Exchange (NYSE) stock
The efficient market hypothesis suggests that all information
(public and private) is incorporated into the price of the stock and
that the prices of stocks with good fundamentals will be bid up to
reflect this situation. Similarly, stocks that are in trouble will be sold
to bring their stock prices in line with their intrinsic value. In other
words, no undervalued or overvalued stocks exist.
If an even chance exists of stock prices rising or falling
because of new information, it doesn’t matter which stocks you
choose or which stocks anyone else chooses for that matter. The
random walk theory implies pure luck in picking stocks.
The efficient market hypothesis is hotly debated, and the jury of
academicians is still undecided about the degree of efficiency of the
market. Even though the efficient market hypothesis has not aroused
the enthusiasm of most investors, the implications are important
because they shatter any illusions of creating overnight wealth in
the stock market. The efficient market hypothesis suggests that few
investors will beat the market averages consistently over a long
period. If the market increases by 10 percent over a one-year period,
most investors will not earn more than an average of 10 percent. In
fact, most investors earn less than the market average because of
transaction costs and fees charged. However, this does not mean that
some investors will not do much worse than 10 percent or will not
earn abnormally high returns.
The following are some anomalies to the efficient market
hypothesis whereby investors have been able to generate superior
returns to beat the market:
* Small-cap stocks. A study by Avner Arbel and Paul Strebel
(1982) suggests that undervalued stocks of small companies
that have been neglected by the investment community
may provide greater returns than the market averages.
Analysts do not cover many of the small firms owing to
their larger perceived risk. This lack of attention to these
neglected small companies means that investors can find
stocks that are trading below their intrinsic value. When
such stocks are discovered by analysts, their prices are bid
up and tend to outperform the larger company stocks. The
result from this study suggests that the securities markets
may not be equally efficient.
* Low P/E ratio stocks. Studies done by S. Basu (1975, 1977)
show that portfolios of stocks with low P/E ratios outperformed
portfolios of stocks with high P/E ratios on a riskadjusted
and non-risk-adjusted basis. This outcome refutes
the semistrong form of the efficient market hypothesis
because P/E ratios of stocks can be obtained from publicly
* Benjamin Graham, who did the pioneering work that
forms the basis of fundamental analysis, realized that
markets were becoming more efficient, thus making it more
difficult to find undervalued stocks. One of his guidelines
was to select low P/E ratio stocks. Table 12–2 lists Graham’s
guidelines for selecting stocks. The greater the number of
yes answers, the more ideal is the stock choice, according to
* Other possible market anomalies that suggest inefficiencies in the
market that result in superior returns. One of these is the
January effect, which finds that stocks that have done poorly
in December may produce superior returns in January
owing to tax selling.
These anomalies should not lead investors to think that the
markets are inefficient. Rather, the anomalies should be viewed
as exceptions. Academic studies lend support for the weak and
semistrong forms of the efficient market hypothesis, which lends
support to the conclusion that very few investors outperform
the markets over extended periods. For investors who feel that the
efficient market hypothesis is not equally efficient with regard
to the pricing of the smaller, lesser-known stocks, fundamental
analysis has a role.
Benjamin Graham’s Guidelines of Stocks to Buy
Stocks that conform to the following criteria would be bought.
1. Is the stock’s P/E ratio less than half the reciprocal of the AAA corporate
bond yield? For example, if the current AAA yield was 5.7* percent, it would
make the reciprocal 17.054 percent (1/0.057), The P/E ratio of the stock
would have to be less than 8.77 percent (1/2 * the reciprocal, or
1/2 * 0.1705) to be bought.
2. Is the stock’s P/E ratio less than 40 percent of the average P/E ratio of the stock
over the past five years?
3. Is the stock’s dividend yield equal to or more than two-thirds the AAA corporate
bond yield? If two-thirds of the current AAA corporate bond yield of 5.7 percent
was 3.8 percent, for the stock to be rated a buy, its dividend yield should equal
to or be greater than 3.8 percent.
4. Is the stock price less than two-thirds of the stock’s book value?
5. Is the stock’s price less than two-thirds of its net current asset value per share?
1. Is the stock’s debt-to-equity ratio less than 1? The total debt of the company
should be less than its total equity.
2. Is the stock’s current ratio equal to 2 or more? The total current assets divided
by the total current liabilities should equal 2 or more.
3. Is the total debt less than twice its net current assets?
4. Is the company’s 10-year average earnings per share (EPS) growth rate greater
than 7 percent?
5. Did the company experience earnings declines of greater than 5 percent in no
more than 2 years out of the past 10 years?
Categories in Trading Mistakes
Lack of Trading Plan
Planning plays a key role in the success or failure of any endeavor
Using too much Leverage
Determining the proper capital requirements for trading is a difficult task
Failure to control Risk
Refusing to employ effective risk control measures can ensure your long-term failure
Lack of Discipline
A lack of discipline can destroy even the most talented and best prepared trader
Useful Advices to Beginning Trader
You can control your success or failure
All about Stocks
Encyclopedia about Stocks. That you should know about Stocks before starting
All terms about Forex market