Implications for investment Analysis

We have examined the development of the efficient market hypothesis, the empirical evidence, and the challenge posed by the critics of the efficient market hypothesis. It is time now to hammer out the investment implications. Before doing that let us briefly recapitulate the main points:

1. The logical development of the efficient market hypothesis, given certain assumption is virtually unassailable. However, the hypothesis rests on assumptions that are somewhat fragile.
2. The empirical evidence regarding the randomness of stock price behavior seems to be overwhelming.
3. The market often adjusts rapidly to public information. Yet on many occasions it assimilates information rather slowly. This appears to be more true of relatively less developed markets like the Indian capital market.
4. The market is rational and orderly in many ways. However, it has its own quirks and flaws; it displays certain anomalies which have not been properly understood and behaves waywardly when psychological influences are strong.

Let us now look at the investment implications of the observations which are indeed of a mixed nature made above.

The substantial evidence in favor of the randomness of stock price behavior suggest that technical analysis (which is based on the premise that stock prices follow certain patterns) represents useless market folklore.

Being somewhat incautious, one will climb out on a limb and argue that no technical scheme whatever would work or any length of time.

Technical analysts, of course vehemently dispute such an assertion and argue that the tests employed by the advocates of random walk theory are too naïve to reveal the kinds of patterns and dependencies technical analysts perceive. Though there may be some merit in this rebuttal, the overwhelming evidence on randomness certainly suggest that technical analysis is of dubious value.

Routine and conventional fundamental analysis is not of much help in identifying profitable courses of action, more so when you are looking at actively traded securities. We have a curious paradox here. The efficiency of the market place depends on the presence of numerous investors who make competent efforts to analyze information and take appropriate actions based on their analysis. If they abandon their work, the efficiency of the market would decline. Yet, the efficiency of the marketplace renders their efforts worthless. Though striking this paradox is not different from the paradox of all efficient competitive markets.

The key levers for earning superior rates of return are:

1. Early action on any new development
2. Sensitivity to market imperfections and anomalies
3. Use of original, unconventional, and innovative modes of analysis
4. Access to inside information and its sensible interpretations.
5. An independent judgment that is not affected by market psychology.

Despite the anomalies and puzzles and the challenge of behavioralists and their sympathizers, the substantial evidence in favor of the efficient market hypothesis cannot be gain said.

The advocates of efficient market hypothesis argue that it is not surprising that several anomalies and puzzles have been discovered. When data is mined extensively one is bound to find a number of patterns. Even a set of random numbers generated by a computer will appear to have some pattern after the fact. Those patterns, however are spurious and will not be replicated another generation of random numbers. Many scholars feel that the same is true of stock prices. William Sharpe puts it more vividly: If you torture the data long enough it will confess to any crime. As an extreme example of data mining, Leinweber, who sifted through United Nations CD-Rom found that historically the best predictor of the S&P 500 was butter production in Bangladesh.