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 so-called 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 equilibriumreturn. This implies that it is impossible to beat the market. Many studies shedlight on whether investment advisers and mutual funds (some of which charge steep sales commissions to people who purchase them) beat the market. One common testthat 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.
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 equilibriumreturn. This implies that it is impossible to beat the market. Many studies shedlight on whether investment advisers and mutual funds (some of which charge steep sales commissions to people who purchase them) beat the market. One common testthat 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 beencompared to a group of stocks chosen by putting a copy of the financial page of the newspaper on a dartboard and throwing darts. 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 onlyadvisers who had been successful in the past in predicting the stock market, theadvisers still didn’t regularly beat the dartboard.
Consistent with the efficient market hypothesis, mutual funds are also not found to beat the market. Mutual funds not only do not outperform the market on average, but when they are separated into groups according to whether they had the highest or lowest profits in a chosen period, the mutual funds that did well in the first period did not beat the market in the second period.
The conclusion from the study of investment advisers and mutual fund performance is this: Having performed well in the past does not indicate that an investment adviser or a mutual fund will perform well in the future. This is not pleasing news to investment advisers, but it is exactly what the efficient market hypothesis predicts. It says that some advisers will be lucky and some will be unlucky. Being lucky does not mean that a forecaster actually has the ability to beat the market.
Do Stock Prices Reflect Publicly Available Information? The efficient market hypothesis predicts that stock prices will reflect all publicly available information. Thus, if information is already publicly available, a positive announcement about a company will not, on average, raise the price of its stock because this information is already reflected in the stock price. Early empirical evidence also confirmed this conjecture from the efficient market hypothesis: Favorable earnings announcementsor announcements of stock splits (a division of a share of stock into multipleshares, which is usually followed by higher earnings) do not, on average, causestock prices to rise.
Random-Walk Behavior of Stock Prices The term random walk describes the movements of a variable whose future changes cannot be predicted (are random) because, given today’s value, the variable is just as likely to fall as to rise. An important implication of the efficient market hypothesis is that stock prices should approximately follow a random walk; that is, future changes in stock prices should, for all practical purposes, be unpredictable. The random-walk implication of the efficient market hypothesis is the one most commonly mentioned in the press because it is the most readily comprehensible to the public. In fact, when people mention the “random-walk theory of stock prices,” they are in reality referring to the efficient market hypothesis.
Technical Analysis A popular technique used to predict stock prices, called technical analysis, is to study past stock price data and search for patterns such as trends and regular cycles. Rules for when to buy and sell stocks are then established on the basis of the patterns that emerge. The efficient market hypothesis suggests that technical analysis is a waste of time. The simplest way to understand why is to use the random-walk result derived from the efficient market hypothesis that holds that past stock price data cannot help predict changes. Therefore, technical analysis, which relies on such data to produce its forecasts, cannot successfully predict changes in stock prices.
Two types of tests bear directly on the value of technical analysis. The first performs the empirical analysis described earlier to evaluate the performance of any financial analyst, technical or otherwise. The results are exactly what the efficient market hypothesis predicts: Technical analysts fare no better than other financial analysts; on average, they do not outperform the market, and successful past forecasting does not imply that their forecasts will outperform the market in the future. The second type of test takes the rules developed in technical analysis for when to buy and sell stocks and applies them to new data. The performance of these rules is then evaluated by the profits that would have been made using them. These tests also discredit technical analysis: It does not outperformthe overall market.
Consistent with the efficient market hypothesis, mutual funds are also not found to beat the market. Mutual funds not only do not outperform the market on average, but when they are separated into groups according to whether they had the highest or lowest profits in a chosen period, the mutual funds that did well in the first period did not beat the market in the second period.
The conclusion from the study of investment advisers and mutual fund performance is this: Having performed well in the past does not indicate that an investment adviser or a mutual fund will perform well in the future. This is not pleasing news to investment advisers, but it is exactly what the efficient market hypothesis predicts. It says that some advisers will be lucky and some will be unlucky. Being lucky does not mean that a forecaster actually has the ability to beat the market.
Do Stock Prices Reflect Publicly Available Information? The efficient market hypothesis predicts that stock prices will reflect all publicly available information. Thus, if information is already publicly available, a positive announcement about a company will not, on average, raise the price of its stock because this information is already reflected in the stock price. Early empirical evidence also confirmed this conjecture from the efficient market hypothesis: Favorable earnings announcementsor announcements of stock splits (a division of a share of stock into multipleshares, which is usually followed by higher earnings) do not, on average, causestock prices to rise.
Random-Walk Behavior of Stock Prices The term random walk describes the movements of a variable whose future changes cannot be predicted (are random) because, given today’s value, the variable is just as likely to fall as to rise. An important implication of the efficient market hypothesis is that stock prices should approximately follow a random walk; that is, future changes in stock prices should, for all practical purposes, be unpredictable. The random-walk implication of the efficient market hypothesis is the one most commonly mentioned in the press because it is the most readily comprehensible to the public. In fact, when people mention the “random-walk theory of stock prices,” they are in reality referring to the efficient market hypothesis.
Technical Analysis A popular technique used to predict stock prices, called technical analysis, is to study past stock price data and search for patterns such as trends and regular cycles. Rules for when to buy and sell stocks are then established on the basis of the patterns that emerge. The efficient market hypothesis suggests that technical analysis is a waste of time. The simplest way to understand why is to use the random-walk result derived from the efficient market hypothesis that holds that past stock price data cannot help predict changes. Therefore, technical analysis, which relies on such data to produce its forecasts, cannot successfully predict changes in stock prices.
Two types of tests bear directly on the value of technical analysis. The first performs the empirical analysis described earlier to evaluate the performance of any financial analyst, technical or otherwise. The results are exactly what the efficient market hypothesis predicts: Technical analysts fare no better than other financial analysts; on average, they do not outperform the market, and successful past forecasting does not imply that their forecasts will outperform the market in the future. The second type of test takes the rules developed in technical analysis for when to buy and sell stocks and applies them to new data. The performance of these rules is then evaluated by the profits that would have been made using them. These tests also discredit technical analysis: It does not outperformthe overall market.
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