Valuation
Appendix to Chapter
7
Evidence on the Efficient Market Hypothesis
Early evidence on the efficient market hypothesis was quite favorable to it. In recent years, however, deeper analysis of the evidence suggests that the hypothesis may not always be entirely correct. Let’s first look at the earlier evidence in favor of the hypothesis and then examine some of the more recent evidence that casts some doubt on it.
EVIDENCE IN FAVOR OF MARKET EFFICIENCY
Evidence in favor of market efficiency has examined the performance of investment analysts and mutual funds, whether stock prices reflect publicly available information, the random-walk behavior of stock prices, and the success of technical analysis.
Performance of Investment Analysts and Mutual Funds
We have seen that one implication of the efficient market hypothesis is that when purchasing a security, you cannot expect to earn an abnormally high return, a return greater than the equilibrium return. This implies that it is impossible to beat the market. Many studies shed light on whether investment advisers and mutual funds (some of which charge steep sales commissions to people who purchase them) beat the market. One common test that has been performed is to take buy and sell recommendations from a group of advisers or mutual funds and compare the performance of the resulting selection of stocks with the market as a whole. Sometimes the advisers’ choices have even been compared to a group of stocks chosen by throwing darts at a copy of the financial page of the newspaper tacked to a dartboard. The Wall Street Journal, for example, used to have a regular feature called “Investment Dartboard” that compared how well stocks picked by investment advisers did relative to stocks picked by throwing darts. Did the advisers win? To their embarrassment, the dartboard beat them as often as they beat the dartboard. Furthermore, even when the comparison included only advisers who had been successful in the past in predicting
7
Evidence on the Efficient Market Hypothesis
Early evidence on the efficient market hypothesis was quite favorable to it. In recent years, however, deeper analysis of the evidence suggests that the hypothesis may not always be entirely correct. Let’s first look at the earlier evidence in favor of the hypothesis and then examine some of the more recent evidence that casts some doubt on it.
EVIDENCE IN FAVOR OF MARKET EFFICIENCY
Evidence in favor of market efficiency has examined the performance of investment analysts and mutual funds, whether stock prices reflect publicly available information, the random-walk behavior of stock prices, and the success of technical analysis.
Performance of Investment Analysts and Mutual Funds
We have seen that one implication of the efficient market hypothesis is that when purchasing a security, you cannot expect to earn an abnormally high return, a return greater than the equilibrium return. This implies that it is impossible to beat the market. Many studies shed light on whether investment advisers and mutual funds (some of which charge steep sales commissions to people who purchase them) beat the market. One common test that has been performed is to take buy and sell recommendations from a group of advisers or mutual funds and compare the performance of the resulting selection of stocks with the market as a whole. Sometimes the advisers’ choices have even been compared to a group of stocks chosen by throwing darts at a copy of the financial page of the newspaper tacked to a dartboard. The Wall Street Journal, for example, used to have a regular feature called “Investment Dartboard” that compared how well stocks picked by investment advisers did relative to stocks picked by throwing darts. Did the advisers win? To their embarrassment, the dartboard beat them as often as they beat the dartboard. Furthermore, even when the comparison included only advisers who had been successful in the past in predicting