Efficient market hypothesis – A theory that had and is misguiding generations

By Aditya Alamuri & Mounika Duvva

The efficient market hypothesis which states that all the relevant information is factored in by the market and therefore one cannot make abnormal returns can only be practiced on paper and the reality associated with the same is far different from what the so called ‘white paper’ propagates. The flow of information that is entering the markets have actually made the entire financial ecosystem more volatile and this new information which is said to ‘walk randomly’ had, is and will always create arbitrage opportunities. With the emergence of globalization and interdependence upon economies, we observe that the loopholes in the EMH have continued to rise, thus making the theory obsolete.

Strong form market efficiency – A myth

A market is 100% efficient only when all the players in the market have sound knowledge of the principles that guide and run the market. Yes, we are referring to financial literacy of the investors who operate in the market. The financial institutions such as banks etc. enjoy superior confidence, which is placed on them by the investors. Therefore, we find that the market is being run on emotions of the investors.

Chaos is an everyday phenomenon in the markets as people are confused about what they are doing in the market; are they trading or are they investing? This chaos is due to their low understanding of the markets and the way these institutions function. These retail investors lack the skills and the sophisticated models to track the markets, thus failing in the stock selection criteria due to poor research about the same. Also, people invest in IPOs and stocks which are very volatile, thus making their fortune shop to the tunes of the market. The investors are driven by their greed to earn more and therefore follow the market rallies without having full knowledge of why the bull run is happening.  The vice versa takes place when the market is bear gripped and these ill-informed investors sell their financial assets in panic.

Arbitrage Opportunities – The modern Holy Grail of the financial markets

In everyday trade, we observe and find many scenarios where the prices displayed on the NSE and the BSE, being different. Also, when we carefully observe these indices, we find that for some stocks, there have been only buyers or only sellers on a given day and this too fuels my previous statement that the prices are different on the indices. Though these stock prices equate and the arbitrage opportunities close, new opening chances are spotted. Therefore, in the entire trading session, with well-built algorithms and constant monitoring of the markets, one will always find arbitrage opportunities thus disregarding the Efficient market hypothesis.

Conclusion

We state that the markets are not efficient due to poor regulatory features. Also, a market is made up of many parties and when a significant portion of the same is ill-informed, then one cannot call the market, on the whole, to be efficient.