The Problems with the Efficiency Market Hypothesis: Critics and Anomalies

Abstract

As quoted by Warren Edward Buffett: “I’d be a bum on the street with a tin cup if the markets were always efficient”. It shows that markets are not always efficiency. In this paper, we will discuss about the dot-com bubble and also Crash of 1987. According to Efficiency Market Hypothesis, the market and market participants are rational. However, we are convinced by Malkiel that the both cases show that the market participants are not rational. The markets overreact to the news in the crash of 1987 which causing the tremendous falling about 22.6% of Dow Jones Average Index. In dot-com bubble, investors are not rational as they exhibit trend chasing characteristic. In the second section, several anomalies (post-earnings-announcement drift, January effect, small firm effect, neglected firm effect and PE ratio effect) will be discussed in this paper. These empirical observations and pattern of returns contradict the efficiency market hypothesis.

1.0 Introduction

Efficient market hypothesis is the condition or hypothesis that the market prices fully reflect available information about the securities and it is the idea that information is quickly and efficiently incorporated into security prices at any point in time, so that old information cannot be used to forecast the drift of future price. Thus, efficient market hypothesis can be associated with the idea of random walk. (Malkiel, 2003) Random Walk is the notion that stock prices changes are random and unpredictable. For the notion of random walk, the information can be reflected in stock price immediately and the tomorrow’s price of stock could only be affected by tomorrow’s news. However, many scholars start to believe that the stock prices can be partially predictable by the start of twenty-first century. There are three version of efficiency market hypothesis. The weak-form hypothesis states that the future prices cannot be predicted by analysing the historical prices and the semi-strong form...