The Efficient Market Hypothesis on Trial:

A Survey

by Philip S. Russel and Violet M. Torbey



a peer-reviewed article Philip S. Russel  is an Assistant Professor of Finance at the School of Business Administration, Philadelphia University. 

Violet M. Torbey and  is both an Assistant Professor of Finance at the School of Business, Bond University, Gold Coast, Australia and a visiting Financial Economist with the U.S. Securities and Exchange Commission, Office of Economic Analysis, Washington, D.C.


Abstract: The hitherto dominant paradigm in financial market research, the Efficient Market Hypothesis (EMH), has been put on trial  recently and subjected to critical re-examination. The preliminary evidence indicates that the initial confidence in the Efficient Market Hypothesis might have been misplaced. It is observed that financial equilibrium models based on EMH fail to depict trading operations in the real world. Various anomalies and inconsistent results call for refinement of the existing paradigm. It is proposed in this article that a more coherent theory of stock market behavior can be developed by incorporating Keynesian ideologies on the speculative behavior of  investors.

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"I'd be a bum in the street with a tin cup if the markets were efficient." 

Warren Buffett


The movement of prices in the stock market are among a few phenomena that have cut across the boundaries of academic disciplines and have a cumulative research evidence spanning almost a century. Today the field of financial market research seems to be at the exciting stage of "crisis" (to use Kuhn's analogy) - past results are being questioned, and new solutions are being proposed. There seems to be growing dissatisfaction among academic researchers with the body of literature developed on the assumption of market efficiency. Keynesian ideologies on speculative market phenomena (hitherto ignored) are being resurrected to explain the volatile nature of the stock market. While only time will tell whether or not the present crisis will lead to a revolution in thought and development of a coherent theory of stock market behavior, it seems appropriate at this point to take stock of the current literature in the area of market efficiency and to identify the emerging lines of thought.

This essay is organized as follows: The first section provides a brief historical perspective on EMH. In this section it is observed that the initial euphoria about the EMH has waned and that conflicting opinions on market behavior have provided the impetus for the current debate. The next section identifies some market anomalies and the resultant alternate theories for explaining market behavior. The third section provides Keynes' perspective on stock market behavior. A short summary followed by some directions for future research concludes the paper.

1. Efficient Market Hypothesis 

la. The Specifics

First, what do we mean by an Efficient Market Hypothesis? The simplest explanation would be that securities prices reflect information. Fama (1970) made a distinction between three forms of EMH: (a) the weak form, (b) the semi-strong form, and (c) the strong form. However, it is the semi-strong form of EMH that has formed the basis for most empirical research.

The strong form suggests that securities prices reflect all available information, even private information. Seyhun (1986, 1998) provides sufficient evidence that insiders profit from trading on information not already incorporated into prices. Hence the strong form does not hold in a world with an uneven playing field. The semi-strong form of EMH asserts that security prices reflect all publicly available information. There are no undervalued or overvalued securities and thus, trading rules are incapable of producing superior returns. When new information is released, it is fully incorporated into the price rather speedily. The availability of intraday data enabled tests which offer evidence of public information impacting stock prices within minutes (Patell and Wolfson, 1984, Gosnell, Keown and Pinkerton, 1996). The weak form of the hypothesis suggests that past prices or returns reflect future prices or returns. The inconsistent performance of technical analysts suggests this form holds. However, Fama (1991) expanded the concept of the weak form to include predicting future returns with the use of accounting or macroeconomic variables. As discussed below, the evidence of predictability of returns provides an argument against the weak form.

While the semi-strong form of EMH has formed the basis for most empirical research, recent research has expanded the tests of market efficiency to include the weak form of EMH. There continues to be disagreement on the degree of market efficiency. This is exacerbated by the joint hypothesis problem. Tests of market efficiency must be based on an asset-pricing model. If the evidence is against market efficiency, it may be because the market is inefficient, or it may be that the model is incorrect. The literature documented below presents evidence of inefficiencies based on existing models and more recent research findings that cast doubt on these models.

lb. The Initial Euphoria and Subsequent Discontentment

The EMH has provided the theoretical basis for much of the financial market research during the seventies and the eighties. In the past, most of the evidence seems to have been consistent with the EMH. [1] Prices were seen to follow a random walk model and the predictable variations in equity returns, if any, were found to be statistically insignificant. While most of the studies in the seventies focused on predicting prices from past prices, studies in the eighties also looked at the possibility of forecasting based on variables such as dividend yield (e.g. Fama & French [1988]), P/E ratios (e.g. Campbell and Shiller [1988]), and term structure variables (e.g. Harvey [1991]). Studies in the nineties looked at inadequacies of current asset pricing models.

The maintained hypothesis of EMH also stimulated a plethora of studies that looked, among other things, at the reaction of the stock market to the announcement of various events such as earnings (e.g. Ball & Brown [1968]), stock splits (e.g. Fama, Fisher, Jensen and Roll [1969]), capital expenditure (e.g. McConnell and Muscarella, [1985]), divestitures (e.g. Klein [1986]), and takeovers (e.g. Jensen and Ruback [1983]). The usefulness or relevance of the information was judged based on the market activity associated with a particular event. In general, the typical results from event studies showed that security prices seemed to adjust to new information within a day of the event announcement, an inference that is consistent with the EMH. [2] Even though there is considerable evidence regarding the existence of efficient markets, one has to bear in mind that there are no universally accepted definitions of crucial terms such as abnormal returns, economic value, and even the null hypothesis of market efficiency. To this list of caveats, one could add the limitations of econometric procedures on which the empirical tests are based.

The early euphoric research of the seventies was followed by a more cautioned and critical approach to the EMH in the eighties and nineties. Researchers repeatedly challenged the studies based on EMH by raising critical questions such as: Can the movement in prices be fully attributed to the announcement of events? Do public announcements affect prices at all? and What could be some of the other factors affecting price movements?. For example, Roll (1988) argues that most price movements for individual stocks cannot be traced to public announcements. In their analysis of the aggregate stock market, Cutler, Poterba and Summers (1989) reach similar conclusions. They report that there is little, if any, correlation between the greatest aggregate market movement and public release of important information. More recently, Haugen and Baker (1996) in their analysis of determinants of returns in five countries conclude that "none of the factors related to sensitivities to macroeconomic variables seem to be important determinants of expected stock returns".

1c. The Current Debate

The accumulating evidence suggests that stock prices can be predicted with a fair degree of reliability. Two competing explanations have been offered for such behavior. Proponents of EMH (e.g. Fama and French [1995]) maintain that such predictability results from time-varying equilibrium expected returns generated by rational pricing in an efficient market that compensates for the level of risk undertaken. Critics of EMH (e.g. La Porta, Lakonishok, Shliefer, and Vishny [1997]) argue that the predictability of stock returns reflects the psychological factors, social movements, noise trading, and fashions or "fads" of irrational investors in a speculative market. The question about whether predictability of returns represents rational variations in expected returns or arises due to irrational speculative deviations from theoretical values has provided the impetus for fervent intellectual inquiries in the recent years. The remainder of this paper is motivated largely by this issue, and places greater emphasis on the speculative aspect.

2. Evidence Against EMH and Alternate Theories of Market Behavior

2a. Market Anomalies

The EMH became controversial especially after the detection of certain anomalies in the capital markets. Some of the main anomalies that have been identified are as follows:

A. The January Effect: Rozeff and Kinney (1976) were the first to document evidence of higher mean returns in January as compared to other months. Using NYSE stocks for the period 1904-1974, they find that the average return for the month of January was 3.48 percent as compared to only .42 percent for the other months. Later studies document the effect persists in more recent years: Bhardwaj and Brooks (1992) for 1977-1986 and Eleswarapu and Reinganum (1993) for 1961-1990. The effect has been found to be present in other countries as well (Gultekin and Gultekin, 1983). The January effect has also been documented for bonds by Chang and Pinegar (1986). Maxwell (1998) shows that the bond market effect is strong for non-investment grade bonds, but not for investment grade bonds. More recently, Bhabra, Dhillon and Ramirez (1999) document a November effect , which is observed only after the Tax Reform Act of 1986. They also find that the January effect is stronger since 1986. Taken together, their results support a tax-loss selling explanation of the effect.

B. The Weekend Effect (or Monday Effect): French (1980) analyzes daily returns of stocks for the period 1953-1977 and finds that there is a tendency for returns to be negative on Mondays whereas they are positive on the other days of the week. He notes that these negative returns are "caused only by the weekend effect and not by a general closed-market effect". A trading strategy, which would be profitable in this case, would be to buy stocks on Monday and sell them on Friday. Kamara (1997) shows that the S&P 500 has no significant Monday effect after April 1982, yet he finds the Monday effect undiminished from 1962-1993 for a portfolio of smaller U.S. stocks. Internationally, Agrawal and Tandon (1994) find significantly negative returns on Monday in nine countries and on Tuesday in eight countries, yet large and positive returns on Friday in 17 of the 18 countries studied. However their data do not extend beyond 1987. Steeley (2001) finds that the weekend effect in the UK has disappeared in the 1990s.

C. Other Seasonal Effects: Holiday and turn of the month effects have been well documented over time and across countries. Lakonishok and Smidt (1988) show that US stock returns are significantly higher at the turn of the month, defined as the last and first three trading days of the month. Ariel (1987) shows that returns tend to be higher on the last day of the month. Cadsby and Ratner (1992) find similar turn of month effects in some countries and not in others. Ziemba (1991) finds evidence of a turn of month effect for Japan when turn of month is defined as the last five and first two trading days of the month. Hensel and Ziemba (1996) and Kunkel and Compton (1998) show how abnormal returns can be earned by exploiting this anomaly. Lakonishok and Smidt (1988), Ariel (1990), and Cadsby and Ratner (1992) all provide evidence to show that returns are, on average, higher the day before a holiday, than on other trading days. The latter paper shows this for countries other than the U.S. Brockman and Michayluk (1998) describe the pre-holiday effect as one of the oldest and most consistent of all seasonal regularities.

D. Small Firm Effect: Banz (1981) published one of the earliest articles on the 'small-firm effect' which is also known as the 'size-effect'. His analysis of the 1936-1975 period reveals that excess returns would have been earned by holding stocks of low capitalization companies. Supporting evidence is provided by Reinganum (1981) who reports that the risk adjusted annual return of small firms was greater than 20 percent. If the market were efficient, one would expect the prices of stocks of these companies to go up to a level where the risk adjusted returns to future investors would be normal. But this did not happen.

E. P/E Ratio Effect: Sanjoy Basu (1977) shows that stocks of companies with low P/E ratios earned a premium for investors during the period 1957-1971. An investor who held the low P/E ratio portfolio earned higher returns than an investor who held the entire sample of stocks. These results also contradict the EMH. Campbell and Shiller (1988b) show P/E ratios have reliable forecast power. Fama and French (1995) find that market and size factors in earnings help explain market and size factors in returns. Dechow, Hutton, Meulbroek and Sloan (2001) document that short-sellers position themselves in stocks of firms with low earnings to price ratios since they are known to have lower future returns.

F. Value-Line Enigma: The Value-Line organization divides the firm into five groups and ranks them according to their estimated performance based on publicly available information. Over a five year period starting from 1965, returns to investors correspond to the rankings given to firms. That is, higher ranking firms earned higher returns. Several researchers (e.g. Stickel, 1985) find positive risk-adjusted abnormal (above average) returns using value line rankings to form trading strategies, thus challenging the EMH.

G. Over/Under Reaction of Stock Prices to Earnings Announcements: There is substantial documented evidence on both over and under-reaction to earnings announcements. DeBondt and Thaler (1985, 1987) present evidence that is consistent with stock prices overreacting to current changes in earnings. They report positive (negative) estimated abnormal stock returns for portfolios that previously generated inferior (superior) stock price and earning performance. This could be construed as the prior period stock price behavior overreacting to earnings developments (Bernard, 1993). Such interpretation has been challenged by Zarowin (1989) but is supported by DeBondt and Thaler (1990). Bernard (1993) provides evidence that is consistent with the initial reaction being too small, and being completed over a period of at least six months. Ou and Penman (1989) also argue that the market underutilizes financial statement information. Bernard (1993) further notes that such anomalies are not due to research design flaws, inappropriate adjustment for risk, or transaction costs. Thus, the evidence suggests that information is not impounded in prices instantaneously as the EMH would predict.

H. Standard & Poor’s (S&P) Index effect: Harris and Gurel (1986) and Shleifer (1986) find a surprising increase in share prices (up to 3 percent) on the announcement of a stock's inclusion into the S&P 500 index. Since in an efficient market only information should change prices, the positive stock price reaction appears to be contrary to the EMH because there is no new information about the firm other than its inclusion in the index. [3]

I. Pricing of Closed-end Funds: The Investment Company Act of 1940 regards all investment funds that do not continuously issue and redeem their shares as closed-end funds. Unlike open-end funds, closed-end funds do not stand ready to sell or repurchase their securities at the net asset value per share. [4] They float a fixed number of shares in an initial public offering and after that, investors wishing to buy or sell shares of a closed-end funds must do so in the secondary market. [5] The prices in the secondary market are dictated by the market forces of demand and supply which may not be directly linked to the fund’s fundamental or net asset value. Malkiel (1977) argues that the market valuation of closed-end investment company shares reflects mispricing. As he notes, "The pricing of closed-end funds does then seem to provide an illustration of market imperfection in capital-asset pricing." [Malkiel, 847]  In general, the funds have been shown to trade at a discount relative to their net asset values (See Malkiel, 1977; Brickley and Schallheim, 1985; Lee, Shleifer and Thaler, 1991). Between 1970 and 1990, the average discount on closed-end funds ranged between 5 to 20 percent. The existence of discounts clearly contradicts the value additivity principle of efficient and frictionless capital markets. [6] Reports from the popular press have also commented on mispricing in the closed-end fund market. As Laderman notes in Business Week (March 1, 1993), "America’s financial markets are the most efficient in the world. But there’s one corner where pockets of inefficiency still exist: closed-end funds".

J. The Distressed Securities Market: While the academic literature largely suggests that stocks in the distressed securities market are efficiently priced (e.g. Ma and Weed [1986], Weinstein [1987], Fridson and Cherry [1990], Blume, Keim and Patel [1991], Cornell and Green [1991], Eberhart and Sweeney [1992], Altman and Eberhart [1994], Buell [1992]) the popular press has frequently conjectured that the stock pricing may be inefficient during the bankruptcy period. [7] For example, the shares of Continental Airlines continued to trade on the AMEX at or about $1.50 per share even after the company had negotiated a plan with its creditors that would provide no distribution to the pre-petition equity holders (WSJ, 1992).  [8] Investors have always sought superior returns in the securities market and vulture investors have attracted a substantial amount of risk-oriented money by offering the possibility of high returns by exploiting the apparent pricing inefficiencies or anomalies in the market for distressed securities. As Philip Schaeffer of Robert Fleming Inc. puts it:

"Returns are attractive because of market's abundant inefficiencies. Investors who find themselves owners of distressed securities do not understand or want to participate in the market and frequently sell at prices substantially below the investments' cost. Distressed investing requires skills involving bankruptcy law, experience and knowledge of the bankruptcy process, and personal contacts. Consequently, the relatively small number of experienced distressed security investors have a significant advantage over other investors who do not have such expertise, knowledge and experience". [Wall Street Journal, 1991]

K. The Weather: Few would argue that sunshine puts people in a good mood. People in good moods make more optimistic choices and judgments. Saunders (1993) shows that the New York Stock Exchange index tends to be negative when it is cloudy. More recently, Hirshleifer and Shumway (2001) analyze data for 26 countries from 1982-1997 and find that stock market returns are positively correlated with sunshine in almost all of the countries studied. Interestingly, they find that snow and rain have no predictive power!

These phenomena have been rightly referred to as anomalies because they cannot be explained within the existing paradigm of EMH. It clearly suggests that information alone is not moving the prices.  [Roll, 1984] [9] These anomalies have led researchers to question the EMH and to investigate alternate modes of theorizing market behavior. Such a development is consistent with Kuhn's (1970) route for progress in knowledge. As he states, "Discovery commences with the awareness of anomaly, i.e., with the recognition that nature has somehow violated the paradigm induced expectations..." [Kuhn, 52]

2b. Volatility Tests, Fads, Noise Trading

The greatest stir in academic circles has been created by the results of volatility tests. These tests are designed to test for rationality of market behavior by examining the volatility of share prices relative to the volatility of the fundamental variables that affect share prices. The first two studies applying these tests were by Shiller (1981) and LeRoy and Porter (1981). Shiller tests a model in which stock prices are the present discounted value of future dividends. LeRoy and Porter use a similar analysis for the bond market. These studies reveal significant volatility in both the stock and bond markets. Fluctuations in actual prices greater than those implied by changes in the fundamental variables affecting the prices are inferred by Shiller as being the result of fads or waves of optimistic or pessimistic market psychology. Schwert (1989) tests for a relation between stock return volatility and economic activity. He finds increased volatility in financial asset returns during recessions which might suggest that operating leverage increases during recessions. He also finds increased volatility in periods where the proportion of new debt issues to new equity issues is larger than a firm’s existing capital structure. This may be interpreted as evidence of financial leverage affecting volatility. However neither of these factors plays a dominant role in explaining the time-varying volatility of the stock market. The volatility tests of Shiller spawned a series of articles. The results of excess volatility in the stock market have been confirmed by Cochrane (1991), West (1988), Campbell and Shiller (1987), Mankiw, Romer, and Shapiro (1985). The tests have been criticized, largely on methodological grounds, by Ackert and Smith (1993), Marsh and Merton (1986), Kleidon (1986) and Flavin (1983).

The empirical evidence provided by volatility tests suggests that movements in stock prices cannot be attributed merely to the rational expectations of investors, but also involve an irrational component. The irrational behavior has been emphasized by Shleifer and Summers (1990) in their exposition of noise trading.

Shleifer and Summers (1990) posit that there are two types of investors in the market: (a) rational speculators or arbitrageurs who trade on the basis of information and (b) noise traders who trade on the basis of imperfect information. Since noise traders act on imperfect information, they will cause prices to deviate from their equilibrium values. It is generally understood that arbitrageurs play the crucial role of stabilizing prices. While arbitrageurs dilute such shifts in prices, they do not eliminate them completely. Shleifer and Summers assert that the assumption of perfect arbitrage made under EMH is not realistic. They observe that arbitrage is limited by two types of risk: (a) fundamental risk and (b) unpredictability of future resale price. Given limited arbitrage, they argue that securities prices do not merely respond to information but also to "changes in expectations or sentiments that are not fully justified by information." [Shleifer and Summers, 23]

An observation of investors’ trading strategies (such as trend chasing) in the market provides evidence for decision making being guided by "noise" rather than by the rational evaluation of information. Further support is provided by professional financial analysts spending considerable resources in trying to predict both the changes in fundamentals and also possible changes in sentiment of other investors. "Tracking these possible indicators of demand makes no sense if prices responded only to fundamental news and not to investor demand. They make perfect sense, in contrast, in a world where investor sentiment moves prices and so predicting changes in this sentiment pays." [Shleifer and Summers, 26]

Black (1986) also argues that noise traders play a useful role in promoting transactions (and thus, influencing prices) as informed traders like to trade with noise traders who provide liquidity. So long as risk is rewarded and there is limited arbitrage, it is unlikely that market forces would eliminate noise traders and maintain efficient prices.

2c. Models of Human Behavior

In a market consisting of human beings, it seems logical that explanations rooted in human and social psychology would hold great promise in advancing our understanding of stock market behavior. More recent research has attempted to explain the persistence of anomalies by adopting a psychological perspective. Evidence in the psychology literature reveals that individuals have limited information processing capabilities, exhibit systematic bias in processing information, are prone to making mistakes, and often tend to rely on the opinion of others.

The damaging attacks on the assumption of human rationality have been spearheaded by Kahneman and Tversky (1986) in their path breaking article on prospect theory. The findings of Kahneman and Tversky have brought into question expected utility theory which has been used descriptively and predictively in the finance and economics literature. They argue that when faced with the complex task of assigning probabilities to uncertain outcomes, individuals often tend to use cognitive heuristics. While useful in reducing the task to a manageable proportion, these heuristics often lead to systematic biases. 

Using simple decision tasks, Kahneman and Tversky are able to demonstrate consistent decision inconsistencies by manipulating the decision frame. While expected utility theory would predict that individuals would evaluate alternatives in terms of the impact on these alternatives on their final wealth position, it is often found that individuals tend to violate expected utility theory predictions by evaluating the situation in terms of gains and losses relative to some reference point. The usefulness and validity of Kahneman and Tversky's propositions have been established by several replications and extensions for situations involving uncertainty by researchers in the fields of accounting, economics, finance, and psychology. Rabin and Thaler (2001) show that expected utility theory’s explanation of risk aversion is not plausible by providing examples of how the theory can be wrong and misleading. They call for a better model of describing choice under uncertainty. It is now widely agreed that the failure of expected utility theory is due to the failure to recognize the psychological principles governing decision tasks.

The literature on cognitive psychology provides a promising framework for analyzing investors' behavior in the stock market. By dropping the stringent assumption of rationality in conventional models, it might be possible to explain some of the persistent anomalous findings. For example, the observation of overreaction is consistent with the finding that subjects, in general, tend to overreact to new information (and ignore base rates). Also, agents often allow their decision to be guided by irrelevant points of reference, a phenomenon discussed under "anchoring and adjustment". Shiller (1984) proposes an alternate model of stock prices that recognizes the influence of social psychology. He attributes the movements in stock prices to social movements. Since there is no objective evidence on which to base their predictions of stock prices, it is suggested that the final opinion of individual investors may largely reflect the opinion of a larger group. Thus, excessive volatility in the stock market is often caused by social "fads" which may have very little rational or logical explanation. 

Shiller (1991, ch.23) also investigates investor behavior during the October 1987 crash by surveying individual investors, institutional investors and stockbrokers. The survey results indicate that most investors traded because of price changes rather than due to news about fundamentals. There appear to have been no major economic developments at that time that triggered the crash. He concludes that it would be wrong to interpret the crash as being due to a change in public opinion about some fundamental economic factor. Seyhun (1990) shows that the 1987 crash was a surprise to corporate insiders. Bates (1991) tests for market expectations prior to the crash by looking at S&P 500 futures options prices. Standard pricing models imply that out of the money (OTM) puts trade at a slight discount to OTM calls. However, OTM puts were, at various times in 1987, priced higher than OTM calls. This overpricing of OTM puts could only imply an expectation of a market crash or increased market volatility if the market fell. The prices reveal that the market expected a crash at the beginning of 1987 or in mid-August, when in fact the market actually peaked, and that there was no expectation of a crash in the two months before October 19.

Research into investor behavior in the securities markets is rapidly expanding with very surprising results, again, results that are often counter to the notion of rational behavior. Hirshleifer and Shumway (2001) find that sunshine is strongly correlated with daily stock returns. Using a unique data set of two years of investor behavior for almost the entire set of investors from Finland, Grinblatt and Keloharju (2001) find that distance, language, and culture influence stock trades. [10] Huberman and Regev (2001) provide an example of how and not when information is released can cause stock price reactions. They study the stock price effect of news about a firm developing a cure for cancer. Although the information had been published a few months earlier in multiple media outlets, the stock price more than quadrupled the day after receiving public attention in the New York Times. Although there was no new information presented, the form in which it was presented caused a permanent price rise.

The efficient market view of prices representing rational valuation of fundamental factors has also been challenged by Summers (1986), who views the market to be highly inefficient. He proposes that pricing should comprise a random walk plus a fad variable. The fad variable is modeled as a slowly mean-reverting stationary process. That is, stock prices will exercise some temporary aberrations, but will eventually return to their equilibrium price levels.

One may argue that market mechanisms may be able to correct the individual decision biases, and thus individual differences may not matter in the aggregate. However, the transition from micro behavior to macro behavior is still not well established. For example, in their study of price differences among similar consumer products, Pratt, Wise and Zeckhauser (1979) demonstrate the failure of the market to correct individual biases.

All arguments aside, the stock market crash of 1987 continues to be problematic for the supporters of EMH. Any attempt to accommodate a 22.7 percent devaluation of the stocks within the theoretical framework of EMH would be a formidable challenge. It seems reasonable to assume that the decline did not occur due to a major shift in the perceived risk or expected future dividend. The crash of 1987 provides further credence to the argument that the market includes a significant number of speculative investors who are guided by "non-fundamental" factors. Thus, the assumption of rationality in conventional models needs to be rethought and reformulated (to conform to reality).

3. Keynes and EMH

John Maynard Keynes

John M. Keynes

The EMH and John Maynard Keynes’ (1936) philosophy represent two extreme views of the stock market. EMH is built on the assumptions of investor rationality. This image is in stark contrast to Keynes’ philosophy in which he pictures the stock market as a "casino" guided by "animal spirit". He argues that investors are guided by short-run speculative motives. They are not interested in assessing the present value of future dividends and holding an investment for a significant period, but rather in estimating the short-run price movements.

In the EMH, investors have a long-term perspective and return on investment is determined by a rational calculation based on changes in the long-run income flows. However, in the Keynesian analysis, investors have shorter horizons and returns represent changes in short-run price fluctuations. As Crotty (1990) notes in his comparison of Keynes, Tobin, and Minsky, stockholders are increasingly concerned with short-term gains and thus have very short-term planning horizons.

If we regard the rational decision making process of the EMH as one that is guided by a complete knowledge of factors governing the decision, it is immediately seen that the EMH is flawed. It fails to provide a realistic framework for the formation of expectations. It is difficult to argue for investor decision making being rational under EMH, given the uncertainty factor. To make a rational decision would involve knowledge of future income flows and also the appropriate discount factor, both of which are unknowable. Like Keynes, many people would agree that few, if any, have sufficient knowledge to make it possible to forecast investment yields.

Thus, in the real world, the investor is not faced with risk (as in EMH analysis), but rather uncertainty, a factor that is given a central role by Keynes. He argues that the future is uncertain and can never be determined. He is also clear in emphasizing that uncertainty is different from probability. The difference can be illustrated with Keynes’ own example. There is risk in the game of roulette where there is a known set of possible outcomes. The risk is that the player does not know which will eventuate, but it is possible to calculate the probability of each outcome occurring. There is, however, uncertainty in knowing the prospect of a future European war. While possible, there is no basis on which to form any calculable probability.

Without objective evidence on which to base their expectation of prices, it becomes intuitively appealing that individuals would base their opinions on other members of their group, an idea emphasized by Keynes. In his analogy of the stock market as a "beauty contest", Keynes notes that the goal of the investor is often to pick the girl that others would consider prettiest rather than choosing the one he/she thinks is prettiest. Keynes proposes that individuals tend to conform to the behavior of the majority or the average. What is irrational at the individual level, becomes conventional and realistic in Keynesian analysis. Thus the stock market can be subject to waves of optimistic or pessimistic sentiment when no solid basis exists for such sentiment, and movements in stock prices are caused largely by changes in the perception of ignorant speculators. He also observes that, while on the one hand, decision making is individualistic, a significant degree of order and coherence is infused by the institutional and social structures.

Capital markets have evolved as highly 'liquid institutions' wherein individual investors can transact at will. Given that transactions occur in an uncertain environment, it is legitimate to hypothesize an element of speculation (gambling spirit) in trading. It is evident that many investors do not buy stocks for "keeps" but rather to resell them in the very near future in the hope of making a gain. Will such investors be guided primarily by changes in fundamental values? Probably not. Anecdotal evidence abounds with day trading as a prime example. While one cannot conclude that the market consists merely of speculators, it is plausible that they may form a substantial group, even with the enormous growth of institutional investors. And, if we agree with that, we will have to concede the debate to Keynes. Keynes’ provocative observations such as "casino", "animal spirits", musical chair", "beauty contest", "mass psychology of ignorant speculators", made in the thirties seem to fit in very well with the stock market behavior of today.


4. Concluding Remarks

4a. Summary

Undoubtedly, the studies based on EMH have made an invaluable contribution to our understanding of the securities market. However, there seems to be growing discontentment with the theory. A limited survey of the contemporary literature shows that criticism of EMH has gained both voice and momentum during recent years. While it is true that the market responds to new information, it is now clear that information is not the only variable affecting security valuation. Recent years have witnessed a new wave of researchers who have provided thought provoking, theoretical arguments and supporting empirical evidence to show that security prices could deviate from their equilibrium values due to psychological factors, fads, and noise trading.

4b. A Look into the Future

While the trial of EMH continues, we expect that the final outcome of the raging debate will be a compromise between competing schools of thought. In our opinion, knowledge of the dynamics of stock market behavior would perhaps be best advanced by adopting a multidisciplinary approach that incorporates both qualitative and quantitative research tools. To this end, we do not call for the abandonment of the EMH paradigm, but rather propose that the hitherto popular EMH paradigm be refined to embody the psychological and speculative aspects of the stock market. As Einhorn (1976) remarked, "We should always be open to the idea of developing new paradigms incorporating some aspect of decision making that has heretofore been neglected." [Einhorn, 205]

4c. Directions for Future Research

It is likely that the quest for a coherent theory of the stock market will continue to stimulate the intellect of academic researchers. It is apparent that, over the years, the field has made much progress and that without such sustained research efforts the issue would remain unresolved. The fresh insights on the speculative component have opened up several avenues for fruitful research. In our opinion, the critics of EMH must continue providing unambiguous, consistent, and direct empirical evidence on the irrational aspect of stock market behavior for their findings to be completely accepted in the discipline. Akerlof and Yellen (1985) show that even small amounts of irrationality could have significant economic effects. De Long, Schleifer, Summers and Waldmann (1989) observe that noise trading can have an adverse impact on other market participants. The social welfare implications of an irrational and speculative stock market, and the policies to control such behavior (if desirable) could be a profitable area for future research. In closing, with the EMH on trial, the field of securities market research is truly at the threshold of an exciting phase.


1. A review of studies in this area would be beyond the scope of this paper. For comprehensive reviews on the subject see Fama (1970, 1991) and Lev (1989).

2. Note that the Ball and Brown (1968) study is an association study. Event studies measure the price impact of an information event in a short window, whereas association studies measure the relative importance of an information event to stock price adjustments in a long window. For example, Ball and Brown show that annual net income number accounts for only twenty percent of the price adjustment in the month of release, implying that most information is captured by more timely media.

3. Proponents of the EMH would argue that the price reaction is either an information effect or a liquidity effect. The fact that S&P decided to include the stock might carry some positive news about the stock. Usually a stock has to meet stringent criteria to be eligible for inclusion in the index. This might be interpreted as good news resulting in a higher price. Alternately, indexing portfolios will include the stock, causing an abrupt increase in the demand for the stock, and improving liquidity for the stock. With improved liquidity, narrower spreads and a lower cost of capital result. The market's required return on the stock decreases, which results in a higher stock price.

4. Net asset value (NAV) is equal to the sum of the market values of all the fund's security positions, plus its cash and minus the liabilities. Shares in open-end funds (mutual funds) can be bought at the prevaililng NAV plus any load charge and redeemed at the NAV minus any redemption fee.

5. Most closed-end funds are listed on the NYSE. A relatively fewer number are traded on the Amex and NASDAQ.

6. For funds selling at a discount, it implies that the fund share price is lower than the per-share new asset value of the portfolio they hold. Thus the value additivity principle is violated.

7. To quote two prominent vulture investors:

(1) George Putnam of New Generation Research (WSJ, 1993), "Clearly, the bankrupt security market is not efficient. But that's why we like it;"

(2) George Soros of Quantum Fund, (Hedge, 1994) "In certain circumstances, financial markets can affect the so-called fundamentals which they are supposed to reflect. When that happens, markets enter into a state of dynamic disequilibrium, and behave quite differently from what would be considered normal by the theory of efficient markets."

8. Another case in point is the common stock of LTV, which continued to trade on the NYSE at $2 a share, which was more than 60 times the value provided for the shares in the reorganization plan.

9. This was based on a study of the information effect of weather condition on the price of orange juice. One would think that such information would account for most of the variation in prices. But Roll found that only a fraction of the movement in orange juice future prices could be attributed to the news.

10. The authors note that these results may not describe other markets.



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