The Theory of

Stock Market
Efficiency:
Accomplishments
and Limitations
Prssented by:
Sayed Mahdi Homayouni
The Theory of Stock Market Efficiency
• Efficient Stock Market: a market where there are large numbers of rational, profit-
maximizers actively competing with each, trying to predict future market values of
individual securities, and where important current information is almost freely available
to all participants …. On the average, competition will cause the full effects of information
on intrinsic values to be reflected “instantaneously” in actual prices (Fama, Eugene; 1965)
Accomplishments of The Theory of Stock Market
Efficiency
• The FFJR study of the stock market reaction to stock splits

• Influencing the climate for other financial economic theories

• M&M’s “dividend” and “capital structure” irrelevance propositions
• Capital Asset Pricing Model (CAPM)
• Black-Scholes option pricing model
Limitations of The Theory of Efficient Markets
• The theory’s influence has been due to insights it provides, not those it
fails to provide

Limitations of The
Theory of Efficient
Markets

Empirical anomalies: Defects in Problems in testing

problems in fitting “efficiency” as a “efficiency” as a
the theory to the model of stock model of stock
data markets markets
Empirical anomalies: problems in fitting the
theory to the data

Empirical Price overreactions

anomalies
Excess volatility
Price underreactions to earnings
The failure of CAPM to explain returns
The explanatory power of non CAPM factors
Seasonal Patterns
Defects in “efficiency” as a model of stock
markets

Defects in Failure to incorporate information acquisition and processing

costs
efficiency
as a Heterogeneous information and beliefs

model of
A brief digression on the role of security analysts
markets
Failure to consider transaction costs

Market microstructure effects

Problems in testing “efficiency” as a model of
stock markets

Problems Changes in riskless rates and risk premiums

in testing
the Trends in real rates and market risk premiums
efficiency
model Changes in betas

Seasonal patterns in betas