It is not possible to outwit the market because all the vital information is mapped out and integrated by the prevailing share prices largely due to efficiencies experienced in the stock exchange market. This theory is supported by the Efficient-market hypothesis.
The hypothesis assumes that during stock exchanges, a fair value prevails on the prices of stocks. As a result, stocks cannot be sold at inflated prices by the investors. Worse still, they may find it cumbersome to buy undervalued stocks. These scenarios explain the reason why the overall market cannot be outperformed.
Even in the event that market timing and expert stock selection are exercised, it still proves to be a heinous task to ‘beat the market’. Therefore, purchasing riskier returns is the most viable means through which investors can gain impressive returns.
Quite a number of assumptions have been put forward in order to meet the expectations of efficient markets. First, securities for profit are usually analyzed by several investors bearing in mind that they aim to make the largest possible gain when trading stocks in the market.
Second, the marketplace receives new, random and fashionable forms of information regarding trading in stocks. In addition, new pieces of information often lead to rapid adjustments in stock prices. An additional assumption is that all the available information should be reflected by stock prices.
It is also crucial to mention that financial theories are generally biased or skewed in nature according to the arguments posed by experts in financial markets (Hirt & Block, 2012).
This implies that certified laws in finance are non-existent. The only existing pieces of information are those that attempt to explain the working mechanics of the markets.
The efficient market hypothesis presents three main versions. To begin with, some of the examples of possessions that can be bought or sold include property, bonds and stocks according to the weak form. In regards to the semi-strong version of the hypothesis, both the existing and new public information affect the prices of stocks.
Changes in prices are witnessed whenever new market information is made available to the public. On the other hand, even the hidden information affects the prices of stocks according to the strong version of the efficient market hypothesis.
While the three forms of the hypothesis tend to be logical, the 2007/2008 global financial turmoil was largely attributed to the strong assumptions of rational markets. In fact, some critics linked such assumptions to the collapse of world economy.
Nevertheless, those who support the hypothesis are of the opinion that future uncertainty must be put into consideration even when propagating the assumptions of the hypothesis. In other words, most individuals enjoy practically efficient markets because the hypothesis does not merely simplify the economic principles of the world.
In order to test for the weak form, a number of methods can be used. The variance ratio test claims that the variance of a serious market cannot progress with the passage of time when the series is stationary (Hirt & Block, 2012). Unit root tests examine whether a particular market aspect is changing with time.
In serial correlation, the financial market experts make use of repeating patterns to establish the possible future trends of the market. In the runs test, the weak form of the market is scrutinized at random using multiple flows of data.
Hu (2014) and Sewell (2012) assert that markets may not fully be efficient in the semi-strong form. According to the two studies, quick adjustment in share prices is experienced when a new piece of information lands to the public. However, the change in market prices for stocks can never guarantee efficiency.
Some forms of market information may mislead investors and occasion major inefficiencies. In addition, excess returns cannot be generated through the technical analysis technique or fundamental analysis methodology (Sewell, 2012).
Although the semi-strong form boasts of unbiased flow of new information, it is crucial to point out that it is not possible to avoid one-sided flow of information and ideas that potentially affect the market.
Hence, instantaneous and relevant alteration of past information should be executed as part and parcel of testing a semi-strong form of the efficient market hypothesis.
Both the insider and publicly available information usually influence share prices when it comes to the strong form of the above hypothesis. Alajbeg, Bubas and Sonje (2012) posit that excess returns cannot be earned by any class or category of investors.
The strong-form efficiency can hardly prevail especially if insider trading laws and private information are legally hindered from infiltrating into the public domain. However, in cases where universal ignorance of laws prevails, the strong-form efficiency can be realized (Hirt & Block, 2012).
Excess returns should not be earned by investors for long within a given market so that it can make it easy to test for the strong version of the hypothesis. In other terms, excessive and consistent earnings should be avoided to facilitate testing of this form of efficiency.
References
Alajbeg, D., Bubas, Z. & Sonje, V. (2012). The efficient market hypothesis: Problems with interpretations of empirical tests. Financial Theory and Practice, 36(1), 53- 72.
Hirt,G. & Block, S. (2012). Fundamentals of investment management. (10th ed.). New York, NY: McGraw-Hill Irwin.
Hu, M. (2014). The Efficient Market Hypothesis and Corporate event waves: Part II. Corporate Finance Review, 18(6), 20-26.
Sewell, M. (2012). The efficient market hypothesis: Empirical evidence. International Journal of Statistics and Probability, 1(2), 164-178.