Strikes against the Efficient Market Theory

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Strikes against the Efficient Market Theory

In the 1980s, academics challenged the efficient market theory. And the October 1987 stock market crash left economists, money managers, and investors asking, "Did the market accurately reflect all publicly available information about these companies before the crash? If so, how could the crash have happened?"

The theory needs some refinement

Even Burton Malkiel, author of the important 1973 book A Random Walk Down Wall Street, himself admitted in the sixth edition of A Random Walk (published in 1995) that "while the reports of the death of the efficient market theory are vastly exaggerated, there do seem to be some techniques of stock selection that may tilt the odds of success in favor of the individual investor."

One reason why

Some of the more notable studies that threw the weak-form efficient market theory into question included research by Eugene Fama and Kenneth French. The duo found that buying stocks that have performed poorly during the past few years led to superior returns over the next few years. In other words, a strategy of buying unpopular stocks can lead to better results than a strategy of buying popular stocks. That’s because the market can get carried away with fashionable stocks, and pessimism can be overdone.

Another reason

Academics uncovered stock market patterns that questioned the semi-strong form of the theory, too. They found that stocks with low price/earnings and/or price/book multiples produce above-average returns over time.

Even more reasons

Finally, researchers have shown how stock splits, dividend increases, insider buying, and merger announcements can dramatically affect stock prices, thereby proving false the strongest-form efficient market theory.