EFFICIENT MARKETS HYPOTHESIS AND OTHER THEORIES OF PRICING IN FINANCIAL MARKETS
Efficient Markets Hypothesis and other theories of pricing in financial markets
Efficient market hypothesis (EMH) is a theory that emerged in the 1960s. It states that it is difficult to predict the market since the price has been set and reflect the current market conditions. It is a disputed and controversial theory. The theory is comparable to other theories of pricing in financial markets. Several strengths and shortcomings emerge through comparison with other theories of pricing (Blinder, et al., 2012). EMH states that no stock is a better buy when compared ...view middle of the document...
Many people oppose the EMH theory, especially by technical analysis. The argument against EMH is that a large number of investors base their expectations on past earnings, prices, records and other indicators. Since stock prices relate to the exceptions for the investors, it is only applicable that future price influence stock prices.
Evidence collected in the past ten years suggest that there is an excess volatility in stock markets. Stock prices regularly change from their fundamental values. The empirical results have led to several alternative theories to detail the observed volatility. It includes fads and noise trading. For instance, the stock market crash that occurred in 1987 led economists to reassess the validity of the EMH (Alexander & Moloney, 2011). An implication of the EMH is that stock price tends to follow a random walk. In essence, the change occurring in the stock prices is difficult to predict. If, based on the information available, a person can determine that the stock price by 10% tomorrow, then the stock market must be failing to incorporate that information (Collum, 2014).
To understand the EMH, changes in the stock market should undergo analysis. When picking stocks, the investor will identify those whose prices are bound to rise in future. In this regard, it is much easier to earn capital gains when the increase occurs. If the forecast is right, then the returns will exceed those in a random selection of stocks (Toporowski, 2010). On the other hand, the EMH says that such a strategy, as applied to the classical theory, will not work. A stock price is a means to show the expectations of a firm on its dividends. It relies on all necessary information about the firm. In order the information to be useful, it must be a surprise. For instance, the recent earnings announcement released by an organization was higher than anticipated. Releasing this information in advance will mean that the expected dividends will include this information (Benner, 2013). In this regard, it is impossible to predict prices. Since surprise information tends to affect stocks, changes in these prices are unpredictable. In statistical terms, each price follows a random walk.
Behavioral decision theory
The tendency of the stock market to react has been of importance of many studies. It emerged from the behavioral decision theory as a means to understand pricing within the financial markets. In this regard, predicting efficient markets based on a rational choice leads to wrong conclusions (Toporowski, 2010). Even though many people are subject to behavioral biases from time to time, the market forces will always act to return prices back to rational levels. This belief relies on the assumption that market forces are powerful enough to overcome any emerging behavioral bias. The irrational beliefs are not powerful enough to change the capacity of arbitrage capital that takes advantage of such irrationalities (Shiller, 2003). An empirical issue...