International Journal of Management Sciences and Business Research, 2012, Vol. 1, Issue 11. (ISSN: 2226-8235) History of the Efficient Market Hypothesis 1) Thian Cheng Lim Abstract Xi’an Jiaotong-Liverpool This paper reviews and summarizes the University work of Sewell (2011). The purpose is to investigate the evolution and development of the Efficient Market 111 Ren’ai Road, Dushu Lake Hypothesis from its inception as theory Higher Education Town, Suzhou of probability to Fama (1965) Industrial Park 215123, China proposition and revision (Fama, 1970; 1991). It discusses the random walk theory and reports the various research papers that have been written on the subject. This paper also clarifies the 2) Xiu Yun Lim debate on the validity of EMH and explains the importance of EMH to National University of Singapore finance theory. Keywords: EMH, history, EMH – Efficient market hypothesis 3) Riuyang Zhai Bentley University I. INTRODUCTION 145 Forest Street, Waltham, Boston There are various ways to describe the MA 02451 USA behavior of the stock market. The efficient market is a concept used to describe the stock market by its level of efficiency in disseminating information. This concept is important for basic assumption in many economic and finance models. EMH as suggested by Fama (1965) is a theoretical proposition, and empirically an efficient market does not exist. Various empirical studies showed that the market is not efficient as described by Fama (1958). Fama reviewed and revised his work and http://www.ijmsbr.com Page 26 International Journal of Management Sciences and Business Research, 2012, Vol. 1, Issue 11. (ISSN: 2226-8235) explain the reason empirical studies did not support his proposition. The purpose of this paper is to investigate the initial concept that leads Fama (1970; 1991) divides market to the proposition of EMH. People had efficiency into three categories of been intrigued by the probability of efficiency: weak-form or how well do beating the market, may it be stocks or past returns predict future returns, semi- other investment market ever since the strong-form or how quickly do security Middle Ages. One of the first works ever prices reflect public information written on the theory of probability is announcements, and strong-form or how Liber de Ludo Aleae (The Book of any investors have private information Games of Chance) written by Girolamo that is not fully reflected in market Cardano a medical doctor from Italy prices. between 1524 to 1550. Furthermore, it is important in the development of the science of probability (Oystein, 1953). There are many practical applications for EMH. For example, stakeholders can measure the performance of the II. EARLY STUDIES ON EMH appointed management by observing the stock price. "In major stock market, a A. Random Walk Hypothesis rational consensus will be reached as to the share prices which best reflect the The random walk hypothesis is a prospects for future cash flows" financial theory stating that stock market (Bowman, 1994)” EMH is of prime prices evolve according to a random importance to the accounting field for walk and thus the prices of the stock performance measurement and financial market cannot be predicted. It is statement reporting (Bowman, 1994, consistent with the efficient-market p2). hypothesis. The idea of random walk was based on Robert Brown observation that grains of pollen suspended in water In an efficient stock market, information had a rapid oscillatory motion when disclosure is a key requirement. If the viewed under a microscope (Brown, managements want the stock market to 1828). The theory that stock prices move correctly value the company's shares, randomly was officially proposed by they must ensure that they provide Maurice Kendall in his 1953 paper, The sufficient information in a timely Analytics of Economic Time Series, Part manner, allowing the market to do so. As 1: Price (Kendall, 1953). Malkiel suggests, "when information arises, the news spreads very quickly and is incorporated into the prices of In 1863 a French stockbroker, Jules securities without delay." (Malkiel, Regnault, observed that the longer you 2003) hold a security, the more you can win or lose on its price variations: the price deviation is directly proportional to the http://www.ijmsbr.com Page 27 International Journal of Management Sciences and Business Research, 2012, Vol. 1, Issue 11. (ISSN: 2226-8235) square root of time (Regnault, 1863). Crash occurred in late October 1929 which, taking into account the full extent and duration of its fallout, was the most Louis Bachelier, another Frenchman devastating stock market crash in the whose Ph.D. dissertation titled "The history of the US. Theory of Speculation" (1900) included some remarkable insights and commentary. Bachelier’s work was way In 1930 Alfred Cowles, 3rd, the ahead of his time and was ignored until American economist and businessman, it was rediscovered by Savage in 1955. founded and funded both the Five years later Karl Pearson, a Econometric Society and its journal, professor and Fellow of the Royal Econometrica. Two years later, Cowles Society, introduced the term random set up the Cowles Commission for walk in the letters pages of Nature Economic Research. Cowles (1933) (Pearson, 1905). Unaware of Bachelier’s analyzed the performance of investment work in 1900, Albert Einstein developed professionals and concluded that stock the equations for Brownian motion market forecasters cannot forecast. (Einstein, 1905). Holbrook Working concluded that stock In 1923 the English economist John returns behave like numbers from a Maynard Keynes clearly stated that lottery (Working, 1934). In 1936 Keynes investors on financial markets are had General Theory of Employment, rewarded not for knowing better than the Interest, and Money (Keynes, 1936) market what the future has in store, but published. He famously compared the rather for risk bearing, this is a stock market with a beauty contest, and consequence of the EMH (Keynes, also claimed that most investors’ 1923). Frederick MacCauley, an decisions can only be as a result of economist, observed that there was a ‘animal spirits’. striking similarity between the fluctuations of the stock market and those of a chance curve which may be Eugen Slutzky showed that sums of obtained by throwing a dice independent random variables may be (MacCauley, 1925). the source of cyclic processes (Slutzky, 1937). In the only paper published before 1960 which found significant inefficiencies, Cowles and Jones found Unquestionable proof of the leptokurtic significant evidence of serial correlation nature of the distribution of returns was in averaged time series indices of stock given by Maurice Olivier in his Paris prices (Cowles and Jones, 1937). doctoral dissertation (Olivier, 1926). Frederick C. Mills, in The Behavior of In 1944, in a continuation of his 1933 Prices (Mills, 1927), proved the publication, Cowles again reported that leptokurtosis of returns. The Wall Street investment professionals do not beat the http://www.ijmsbr.com Page 28 International Journal of Management Sciences and Business Research, 2012, Vol. 1, Issue 11. (ISSN: 2226-8235) market (Cowles, 1944). Holbrook found evidence of the square root of Working showed that in an ideal futures time rule. Regarding the distribution of market it would be impossible for any returns, he finds ‘a larger “tangential professional forecaster to predict price dispersion” in the data at these limits’ changes successfully (Working, 1949). (Osborne, 1959). In 1953 Milton Friedman pointed out Larson (1960) presented the results of an that, due to arbitrage, the case for the application of a new method of time EMH can be made even in situations series analysis. He notes that the where the trading strategies of investors distribution of price changes is ‘very are correlated (Friedman, 1953). Kendall nearly normally distributed for the (1953) analyzed 22 price-series at central 80 per cent of the data, but there weekly intervals and found to his is an excessive number of extreme surprise that they were essentially values.’ Cowles (1960) revisited the random. Also, he was the first to note the results in Cowles and Jones (1937), time dependence of the empirical correcting an error introduced by variance (nonstationarity). Around 1955, averaging, and still finds mixed temporal Leonard Jimmie Savage, who had dependence results. Working (1960) discovered Bachelier’s 1914 publication showed that the use of averages can in the Chicago or Yale library sent half a introduce autocorrelations not present in dozen ‘blue ditto’ postcards to the original series. colleagues, asking ‘does any one of you know him?’ Paul Samuelson was one of the recipients. He couldn’t find the book Houthakker (1961) used stop-loss sell in the MIT library, but he did discover a orders and finds patterns. He also found copy of Bachelier’s PhD thesis leptokurtosis, nonstationarity and (Bernstein, 1992; Taqqu, 2001). suspected non-linearity. Independently of Working (1960), Alexander (1961) realized that spurious autocorrelation In 1956 Bachelier’s name reappeared in could be introduced by averaging; or if economics, this time, as an the probability of a rise is not 0.5. He acknowledged forerunner, in a thesis on concluded that the random walk model options-like pricing by a student of MIT, best fits the data, but found leptokurtosis economist Paul A. Samuelson in the distribution of returns. Also, this (Mandelbrot and Hudson, 2004). paper was the first to test for non-linear Working (1958) built an anticipatory dependence. In the same year, Muth market model. The following year, Harry introduced the rati in 1961. Roberts demonstrated that a random walk will look very much like an actual stock series (Harry, 1959). Meanwhile, In 1962 Mandelbrot first proposed that M. F. M. Osborne showed that the the tails of the distribution of returns logarithm of common-stock prices follow a power law, in IBM Research follows Brownian motion; and also Note NC-87 (Mandelbrot, 1962).