UNIVERSITY OF NAIROBI

SCHOOL OF BUSINESS

MASTERS OF BUSINESS ADMINISTRATION

DFI 605 – FINANCIAL SEMINAR

CLASS PRESENTATION – GROUP 5

TOPIC: EFFICIENT CAPITAL MARKETS THEORY

PRESENTED BY:

1. ALICE NGUMA D61/79053/2010

2. CYRUS M. MURIITHI D61/61646/2010

3. AMBROSE AGENG’A D61/60495/2010

4. ALBANUS M. MUMO D61/61648/2010

5. BENSON M. NGARI D61/61

6. EVALINE A. OMONDI D61/60121/2010

COORDINATOR: MIRIE MWANGI

JANUARY TO APRIL, 2011

 TABLE OF CONTENTS

ABBREVIATIONS........................................................................II

CHAPTER ONE...........................................................................1

1.0 INTRODUCTION.......................................................................................1
1.1 Overview of the Efficient Market Hypothesis............................................................1
1.2 Historical Development of the Efficiency Market Theory...........................................2
1.3 Types of Capital Market Efficiencies.........................................................................3
1.4 The Value of an Efficient Market ..............................................................................3
1.5 Implications of the Efficient Market Hypothesis........................................................4

CHAPTER TWO..........................................................................6

2.0 LITERATURE REVIEW...............................................................................6

2.1 Empirical Evidence...................................................................................................6
2.2 Weak Form Market Efficiency..................................................................................7
2.3 Semi-Strong Form Market Efficiency.........................................................................9
2.4 Strong-Form Market Efficiency................................................................................11
2.5 Efficient Markets and Technical Analysis................................................................12
2.6 Efficient Markets and Fundamental Analysis...........................................................13

CHAPTER THREE......................................................................15

3.0 RESEARCH GAPS...................................................................................15

.............................................................................................16

REFERENCES...............................................................................................17

i
 ABBREVIATIONS

EMH – Efficient Market Hypothesis

NSE – Nairobi Stock Exchange

ii
 CHAPTER ONE
1.0 INTRODUCTION

1.1 Overview of the Efficient Market Hypothesis

Efficient markets theory of financial economics states that the prices reflect all relevant
information that is available about the intrinsic value of the asset. According to Reilly and
Brown (2006) an efficient capital market is one in which security prices adjust rapidly to the
arrival of new information and, therefore the current prices of securities reflect all
information about the security. This is referred to as an informationally efficient market
meaning that one cannot consistently achieve returns in excess of average market returns on a
risk adjusted basis, given the information publicly available at the time the investment is
made.

Reilly and Brown (2006) argue that for a capital market to be termed as efficient several
assumptions are made. An important premise of an efficient market requires that a large
number of profit maximization participants analyze and value securities, independent of the
other. A second assumption is that new information regarding securities comes to the market
in a random fashion, and the timing of one announcement is generally independent of others.
The third assumption is profit maximizing investors adjust security prices rapidly to reflect
the effect of new information. Although the price adjustments may be imperfect, it is
unbiased. Meaning that sometimes the market will over-adjust and other times it will under-
adjust, but it can not be predicted which one will occur at any given time.

The combined effect of: (1). Information coming in a random, independent, unpredictable
fashion and (2) numerous competing investors adjusting stock prices rapidly to reflect this
new information means that one would expect price changes to be independent and random.

Bodie (2009) argues that because security prices adjust to all new information the security
prices should reflect all information that is publicly available at any point in time. Therefore,
the security prices that prevail at any time should be an unbiased reflection of all currently
available information, including the risk involved in owning the security. Therefore, in an
efficient market, the expected returns implicit in the current price of the security should
reflect its risk, which means that investors who buy at these informationally efficient prices
should receive a rate of return that is consistent with the perceived risk of the stock.

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Most of the early work related to efficient capital markets was based on the random walk
hypothesis, which contended that changes in stock prices occurred randomly (Levy 2005).

Fama (1970) presented the efficient market theory in terms of a fair game model, contending
that investors can be confident that a current market price fully reflects all available
information about a security and the reflected return based upon this price is consistent with
risk.

1.2 Historical Development of the Efficiency Market Theory

The Efficient Market Hypothesis was developed by Professor Eugene Fama at the University
of Chicago Booth School Of Business as an academic concept of study through his published
PhD thesis in the early 1960’s at the same school. It was widely accepted up until the 1990’s,
when Behavioural Finance economists, who were a fringe element, became mainstream
(Fama 1970).

The EMH was first expressed by Louis Bachelier, a French mathematician in his 1900
dissertation, “The Theory of Speculation”. His work was largely ignored until the 1950’s.
However, beginning in the 30’s scattered, independent work corroborated his thesis. A small
number of studies indicated the US stock prices and related financial series followed a
random walk model. Research by Alfred Cowles in the 30’s and 40’s suggested that
professional investors were in general, unable to outperform the market (DeBondt 1985).

The Efficient Market Hypothesis emerged as a prominent theory in the mid 1960’s. Paul
Samuelson had begun to circulate Bachelier’s work among economists. In 1964, Bachelier’s
dissertation along with the empirical studies mentioned above, were published in an
anthology edited by Paul Cootner. In 1965, Eugene Fama published his dissertation arguing
for the random walk hypothesis and Samuelson published a proof version of the EMH. In
1970, Fama published a review of both the theory and the evidence for the hypothesis (Olsen
1998).

Some theorists argue that prices ought to accurately reflect fundamental information for a
market to be efficient, however most tests of the efficient market hypothesis, deal with how
fast information is incorporated in prices (Reilly and Brown 2006).

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1.3 Types of Capital Market Efficiencies
Fama (1970) divided the overall efficient capital market hypothesis and the empirical tests of
the hypothesis into three sub-hypothesis. The weak form efficient market hypothesis states
that stock prices fully reflect all market information so any trading rule that uses the past
market data to predict future returns should have no value. The semi strong form asserts that
security prices adjust rapidly to the release of all public information. The strong form
efficiency market states that security prices reflect all information implying that nobody has
private information and no group should be able to derive above average returns consistently.

1.4 The Value of an Efficient Market

It is important that stock markets are efficient for at least three reasons:

To encourage trading in securities – accurate pricing is required if individuals are going to

be encouraged to invest in private and public enterprises. If securities are incorrectly priced
many savers will refuse to invest because of a fear that when they come to sell the price may
be perverse and may not represent the fundamental attractions of the firm. This will seriously
reduce the availability of funds to companies and inhibit growth. Investors need to know they
are paying a fair price and that they will be able to sell at a fair price – that the market is a
“fair game” (Olsen 1998).

To give correct signals to company managers – Since the maximization of shareholder

wealth can be represented by the security price in an efficient market, sound financial
decision-making relies on the correct pricing of the company’s securities. In implementing a
shareholder wealth-enhancing decision the manager will need to be assured that the
implication of the decision is accurately signaled to shareholders and to management through
a rise in the security price. It is important that managers receive feedback on their decisions
from the share market so that they are encouraged to pursue shareholder wealth strategies
(Mishkin 2007).

To help allocate resources – allocation efficiency requires both operating efficiency and
pricing efficiency. If a poorly run company in a declining industry has highly valued
securities because the stock market is not pricing correctly then this firm will be able to issue

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new securities, and thus attract more of society’s savings for use within its business. This
would be wrong for society as the funds would be better used elsewhere (Mishkin 2007).

1.5 Implications of the Efficient Market Hypothesis

The efficient market hypothesis has a number of implications for both the investors and the
companies.

Investors

For the vast majority of people, public information cannot be used to earn abnormal returns
(that is, returns above the normal level for that systematic risk class). The implication is that
fundamental analysis is a waste of money and that so long as efficiency is maintained the
average investor should simply select a suitably diversified-portfolio, thereby avoiding costs
of analysis and transaction (Olsen 1998).

Investors need to press for a greater volume of timely information. Semi-strong efficiency
depends on the quality and quantity of publicly available information, and so companies
should be encouraged by investor pressure, accounting bodies, government rulings and stock
market regulation to provide as much as is compatible with the necessity for some secrecy to
prevent competitors gaining useful knowledge(Reilly 2007).

Companies

Some managers behave as though they believe they can fool shareholders. For example
creative accounting is used to show a more impressive performance than is justified. Most of
the time these tricks are transparent to investors, who are able to interpret the real position,
and security prices do not rise artificially (Mishkin 2007).

There are some circumstances when the drive for short-term boosts to reported earnings
could be positively harmful to shareholders. For example, one firm might tend to overvalue
its stock to boost short-term profitability, another might not write off bad debts. These actions
will result in additional, or at least earlier, taxation payments, which will be harmful to
shareholder wealth (Olsen 1998)

The timing of security issues does not have to be fine-tuned: Consider a team of managers
contemplating a share issue who feel that their securities are currently under-priced because
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the market is low. They opt to delay the sale, hoping that the market will rise to a more
normal level. This defies the logic of the EMH – if the market is efficient the securities are
already correctly priced and it is just as likely that the next move in prices will be down as up.
The past price movements have nothing to say about future movements (Osman 2007).

The situation is somewhat different if the managers have private information that they know
is not yet priced into the securities. In this case if the directors have good news then they
would be wise to wait until after an announcement and subsequent adjustment to the share
price before selling the new securities. Bad news announcements are more tricky – to sell the
securities to new investors while withholding bad news will benefit existing shareholders, but
will result in loss for the new shareholders (Rozeff 1998)

5
 CHAPTER TWO
2.0 LITERATURE REVIEW
The efficient market hypothesis was widely accepted by academic financial economists; it
was generally believed that securities markets were extremely efficient in reflecting
information about individual stocks and about the stock market as a whole. The efficient
market hypothesis is associated with the idea of a “random walk,” (Samuelson 1965). All
subsequent price changes represent random departures from previous prices. The original
empirical work supporting the notion of randomness in stock prices looked at such measures
of short-run serial correlations between successive stock-price changes. This work supported
the view that the stock market has no memory.

2.1 Empirical Evidence

Revolutions often spawn counterrevolutions and the efficient market hypothesis in finance is
no exception. The intellectual dominance of the efficient-market revolution has been
challenged by economists who stress psychological and behavioural elements of stock-price
determination and by econometricians who argue that stock returns are, to a considerable
extent, predictable (Levy 2005).

A generation ago, the efficient market hypothesis was widely accepted by academic financial
economists; for example, Fama’s (1970) influential survey article, “Efficient Capital
Markets.” It was generally believed that securities markets were extremely efficient in
reflecting information about individual stocks and about the stock market as a whole.

The accepted view was that when information arises, the news spreads very quickly and is
incorporated into the prices of securities without delay. Thus, neither technical analysis,
which is the study of past stock prices in an attempt to predict future prices, nor even
fundamental analysis, which is the analysis of financial information such as company
earnings, asset values, etc. to help investors select “undervalued” stocks, would enable an
investor to achieve returns greater than those that could be obtained by holding a randomly
selected portfolio of individual stocks with comparable risk ((Fama 1970).

Fama (1970) classifies the market efficiency into three levels on the basis of the information:
Weak, Semi-strong and Strong forms.

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2.2 Weak Form Market Efficiency
The weak form EMH assumes that current stock prices fully reflect all security market
information, including the historical sequence of prices, rate of return, trading volume data,
and other market generated information, such as odd- lot transactions, block trades and
transactions by exchange specialists (Reilly 2006).

The hypothesis assumes that current market prices already reflect all past returns and any
other security market information, this hypothesis implies that past rates of return and other
historical market data should have no relationship with future rates of return. Therefore, this
hypothesis contends that one should gain little from using any trading rule that decides
whether to buy or sell a security based on past rate of return or any other past security market
data (Reilly 2006).

Wanjohi (2007) studied the relationship between the stock market prices, sales turnover,
profit before tax and dividends from year 2000 to 2004 for all companies listed in NSE.
Studies have shown that earnings announcements, high demand for companies’ products
increases profitability hence high dividend payout are expected. The objective of the study
was to evaluate the relationship between the stock market return, sales turnover, profit before
tax and dividends.

Cross sectional research design was used in the study. Data was collected over a specified
duration of time both dependent and independent variables concurrently. The population
consisted of all companies listed at NSE before year 2000 and had published their financial
statements from January 2000 to December 2004. All the 48 companies listed in the NSE
were included to increase precision. Cross tabulation was used to analyze the data.
Descriptive statistics and time series analysis was used to describe the performance of the
companies over the study period.

The study showed that the relationship between the stock market prices and sales turnover,
profit before tax as well as dividends is uneven from one year to the other and where there is
a relationship it is not significant. Thus the NSE is inefficient in the weak form of EMH.
Stock prices are determined by the expected future earnings of the company and not the
current trends that are depicted by the past performance.

Mburu (2007) studied the relationship between trading volume and stock prices movements
on 20 securities for companies that constitute the NSE 20 share index that remained listed at

7
the NSE and traded between January 2002 and December 2006. The objective of the study
was to determine whether trading volume behaviour has a significant effect on the stock’s
price movements.

Exploratory study was used. The population constituted of 53 companies at the NSE. A
sample of 20 companies which formed the NSE 20 share index, are large in size, actively
traded and traded in large volumes was selected. Trends in prices volume sensitivity was used
to analyze the data. Correlation coefficient test were conducted to assess whether there
existed significant Co- movement between changes in price indices and volume traded.

The price to volume sensitivity for stock making the NSE 20 share index was not found to
deviate from 0. There were no significant causal relationship between the stock prices and
volume of securities traded at NSE. The finding does not substantiate the weak form of EMH
since it shows that past trading volume do not play a role in driving stock prices.

There are various methods to test the dependence of Weak-Form of market efficiency these
include: (1). Serial Correlation test, (2). Short-term predictability, (3). Run Tests, (4).Filter
Rule Tests, (5).Cyclical Tests and (6) Volatility Tests (Reilly 2006).

Time patterns in security returns

A number of studies have reported time patterns in security returns, returns being higher or
lower depending on the time of the day, the day of the week, and the month of the year. Many
researchers working on these variables, and set of data, patterns have been found, and they
are simply random. Some studies have explained that these patterns are partly induced by the
market structure and order flows (Mishkin 2007).

Markets are inefficient because one would expect that the patterns would disappear as
investors exploit them, but due to transactional costs, the return differences are not large
enough to develop a trading strategy to take advantage of them (Mishkin 2007).

Intra-day and Day-of the week patterns

One pattern that has been extensively examined is the difference in return for various days of
the week; returns on Monday are much lower than on other days of the week such as in the
Nairobi Stock Exchange (NSE). Hence, the advice to traders to sell late Friday and purchase
on Monday.

8
Monthly patterns

Extensive research finds that returns in January are substantially higher than returns in other
months. However, the differences in small stocks are much larger than for large stocks thus
most of the high January return effect is associated with small stocks.

January Effect

January effect has been studied in broad; Gultekin (1984) studied January return patters in 17
countries including the United States, whose findings were that much higher returns were
recorded in January than in Non-January months in all the countries.

Kamau (2003) sought to establish if there was turn of the month and January effects on stock
prices at the NSE during the period July 1995 to June 2003 using NSE daily closing prices
and found that it did not suffice.

Holiday Effect

The Holiday Effect anomaly portends that on average, high stock returns are earned on the
day preceding the public holidays than other trading days.

In a study by Osman (2007) to investigate whether the stock returns at the Nairobi Stock
Exchange (NSE) exhibit holiday effect and used regression analysis to find out if the stock
returns around the public holidays were higher compared to the returns of other days of the
week. The T-test (two-tailed test) was applied to assess the significance of the coefficients
derived from the equation. The study used the daily AIG index returns from AIG Investment
Services from 1st January 1998 to 31st December 2006. The population of the study consists
of all the companies constituting the AIG index as at 31st December 2006 i.e. 27 companies,
20 of these constituting the NSE 20 Share Index. The sample included companies listed and
constituting the AIG Index from 1st January 1998 to 31st December 2006 i.e. the 27
companies. Secondary data from AIG Investment Services was used. The duration (period) of
nine years was considered.

The result of the study was that holiday’s do not have a significant impact on stock market
activity at the NSE i.e. there is no holiday effect.

2.3 Semi-Strong Form Market Efficiency

The semi strong- form EMH asserts that security prices adjust rapidly to the release of all
public information; that is, current security prices fully reflect all public information. The
9
semi strong hypothesis encompasses the weak form hypothesis, because all the market
information considered by the weak- form hypothesis, such as stock prices, rates of return
and trading volume is public. Public information, such as earnings and dividend
announcements, price-to -earnings (P/E ratios), dividend yield (D/P ratios), stock splits, news
about the economy and political news (Reilly 2006).

This hypothesis implies that investors who base their decision on any important new
information after it is public should not derive above average risk-adjusted profits from their
transactions, considering the cost of trading because the security price already reflects all
such new public information (Mishkin 2007).

Some of the studies done to support semi strong market efficient hypothesis are:

Dividend announcements

Njeru (2007) sought to test for existence of under reaction anomaly at NSE. Under-reaction
anomaly refers to the tendency of stock prices to continue reacting to important
announcement in the days following the announcement date. A sample of 21 stock dividend
announcement events at NSE covering a 7 year period from January 1999 to 31st December
2005 were tested.

The objective of the study was to examine whether the behaviour of stock prices following
stock dividend announcement show evidence of existence of under-reaction anomaly at NSE.
The study was based on event study design with stock dividend announcement being the
event of importance. A comparison of the returns on the event day and succeeding was done
through analysis of the average cumulative abnormal returns. The population comprised of all
the listed companies at NSE between 1st January 1999 and 31st December 2006 of 48
companies. All companies who declared stock dividends in the period and traded continually
for at least 60 days before the stock bonus announcement were included in the sample. A
comparison period return approach was used in analyzing price movements. The comparison
period being 50 days period starting 60 days before the event and ending 10 days to the event.

The results showed evidence in favour of existence of under-reaction to stock dividends

announcement at the NSE for the period under study. This shows that NSE portrays evidence
of inefficiency in the semi strong form of market efficiency.

10
Banda (2006) conducted a study on Market reaction to shareholders annual general meeting
of company’s listed at Nairobi stock exchange between 1998 to 2001. The study objective
was to investigate whether resolutions passed at AGM trigger unusual movement of securities
traded at Nairobi stock exchange. Event study design was used. The population consisted of
all companies quoted in stock exchange from 1998 to 2001. A sample of 20 companies was
used which constitute NSE share index.

It was found that abnormal returns were observed in post and pre AGM in a number of
securities listed in the stock exchange. Given that a number of issues to be deliberated during
the AGM are public information prior to the AGM.

Stock splits

Stock split is a corporate action in which a company existing securities are dividend into
multiple securities. Stock split increases the number of securities in public company. The
price is adjusted such that the market capitalisation of the company remains the same after
the split, so that dilution does not occur (Bodie 2009).

Fama et al. (1969) performed the first test for semi-strong market efficiency. Using risk-
adjusted return to test for market efficiency with respect to the announcement of stock split,
he found a considerable high abnormal return prior to the announcement of stock split. On the
other hand, after the stock split there is no extraordinary return, and the situation returns to
exactly what EMH predicted.

Block trades

According to Olsen (1998) block trades refers to the purchase or sale by a wealthy individual,
corporation or institution of a large quantity of stocks, bonds, futures, options or other
investments

Market efficiency means the security price should reflect all the information. Block trading
occurs when a large number of stocks are suddenly placed on the market for sale. This causes
imbalance in the supply and demand in the market, as well as being perceived by the market
as negative information (Reilly 2007).

2.4 Strong-Form Market Efficiency

The strong – form EMH contends that stock prices fully reflect all information from public
and private sources. This means that no group of investors has monopolistic access to

11
information relevant to the formation of prices. The strong form EMH encompasses both the
weak- form and the semi strong form EMH. Further, the strong form EMH extends the
assumption of efficient markets, in which prices adjust rapidly to the release of new public
information, to assume perfect markets, in which all information is cost free and available to
everyone at the same time (Reilly 2006)

Testing of EMH in the strong form is conducted in different ways: first, by testing the return
that is earned by the insider; second, using indirect test by examining the return and trading
volume prior to public announcement (Olsen 1998).

Empirical tests of the strong-form version of the efficient markets hypothesis have typically
focused on the profitability of insider trading. If the strong-form efficiency hypothesis is
correct, then insiders should not be able to profit by trading on their private information (Jaffe
1974). Jaffe (1974) finds considerable evidence that insider trades are profitable. A more
recent paper by Rozeff and Zaman (1988) finds that insider profits, after deducting an
assumed 2 percent transaction costs, are 3% per year. Thus, it does not appear to be
consistent with the strong-form of the EMH.

2.5 Efficient Markets and Technical Analysis

Technical analysis is essentially the search for recurrent and predictable patterns in stock
prices (Bodie 2009).According to Bodie (2009) the key to successful technical analysis is a
sluggish response of stocks prices to fundamental supply and demand factors.

Technical analysts are sometimes called chartists because they study records or charts of past
stock prices, hoping to find patterns they can exploit to make a profit.

The assumptions of technical analysis directly oppose the notion of efficient markets. A basic
premise of technical analysis is that stock prices move in trends that persist (Reilly 2007).
Technicians believe that when new information comes to the markets, it is not immediately
available to everyone but is typically disseminated from the informed professionals to the
aggressive investing public and then to the great bulk of investors. Also, technicians contend
that investors do not analyze information and act immediately. This process takes time
(Reilly 2007).

Therefore technicians hypothesize that stock prices move to a new equilibrium after the
release of new information in a gradual manner, which causes trends in stock prices
movements that persists.
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Technical analysts believe that nimble traders can develop systems to detect the beginning of
a movement to a new equilibrium (called a breakout). Hence, they hope to buy or sell the
stock immediately after its break out to take advantage of the subsequent, gradual price
adjustment (Reilly 2007).

The belief in this pattern of price adjustment directly contradicts advocates of the EMH who
believe that security prices adjust to news information very rapidly has stated by Fama in his
1970 hypothesis. If the capital market is weak form efficient then prices fully reflects all
relevant market information so technical trading systems that depend only on past trading
data cannot have any value (Reilly 2007). By the time the information is public, the price
adjustment has taken place. Therefore a purchase or sale using technical trading rule should
not generate abnormal returns after taking account of risk and transaction costs (Reilly 2007).

2.6 Efficient Markets and Fundamental Analysis

According to Bodie (2009) fundamental analysis uses earning and dividend prospects of the
firm, expectations of future interest rates, and risk evaluation of the firm to determine proper
stock prices. It represents an attempt to determine the present discounted value of all the
payments a stockholder will receive from each share of stock. If the value exceeds the stock
price, the fundamental analyst would recommend purchasing the stock. It involves aggregate
market analysis, industry analysis, company analysis and portfolio management.

Fundamental analysts usually start with the study of past earnings and an examination of
company balance sheets. They supplement this analysis with further detailed economic
analysis, ordinarily including an evaluation of the quality of the firm’s management and the
industry prospect (Bodie 2009).

Fundamental analysts believe that, at any time, there is a basic intrinsic value for the
aggregate stock market, various industries, or individual securities and that these value
depend on underlying economic factor (Reilly 2007).

If the prevailing market price differs from the estimated intrinsic value by enough to cover
transaction costs, an investor should take appropriate action. To buy if the market price is
substantially below intrinsic value, and not buy or you sell, if the market price is above the
intrinsic value.

13
Investors who are engaged in fundamental analysis believe that occasionally, market price
and intrinsic value differ but eventually investors recognize the discrepancy and correct it
(Reilly 2007).

Aggregate Market Analysis with Efficient Capital Markets

EMH implies that if you examine only the past economic events, it is unlikely that you will
be able to out perform a buy and hold policy because the market rapidly adjusts to known
economic events. Therefore, if an investor uses historical data to estimate future values and
invest on the basis of the estimates, he will not experience superior risk adjusted returns
(Reilly 2007).

Industry And Company Analysis with Efficient Capital Markets

Wide distribution of returns from different industries and companies clearly justifies industry
and company analysis. EMH does not contradict the potential value of industry and company
analysis but implies that an investor needs to (1) Understand the relevant variables that affect
rate of return and (2) do a superior job of estimating future values of these relevant variables
(Reilly 2007).

The superior analyst or successful investor must understand what variables are relevant to the
valuation process and have the ability and work ethic to do a superior job of estimating these
important valuation variables.

According to Reilly (2007) to determine if an individual is a superior analyst or investor, one

should examine the performance of numerous securities that this analysts or investors
recommends over time in relation to the performance of a set of randomly selected stocks of
the same risk class.

The stock selection of a superior analyst or investor should consistently out perform the
randomly selected stocks. The consistency requirement is crucial because one would expect a
portfolio developed by random selection to outperform the market about half the time (Reilly
2007).

14
 CHAPTER THREE
3.0 RESEARCH GAPS
Investors and researchers have disputed the EMH both empirically and theoretically.
Behavioural economists attribute the imperfections in financial markets to a combination of
cognitive biases such as overconfidence, overreaction, representative bias, information bias
and various other predictable human errors in reasoning and information processing. These
have been researched by psychologists such as Daniel Kahneman, Amos Tversky, Richard
Thaler and Paul Slovic.These errors in reasoning lead most investors to avoid value stocks
and buy growth stocks at expensive prices, which allow those who reason correctly to profit
from bargains in neglected value stocks and overreacted selling of growth stocks. There is
therefore need for further studies to investigate the extent to which financial market
imperfections are affected by these biases and other predictable human errors in reasoning
and information processing.

The financial crisis of 2007-2010 has led to renewed scrutiny and criticism of hypothesis.
Market strategies Jeremy Grantham has stated flatly that the EMH is responsible for the
current financial crisis, claiming that belief in the hypothesis caused financial leaders to have
‘’chronic underestimation of the dangers of asset bubbles breaking’’.Noted financial
journalist Roger Lowenstein blasted the theory declaring ‘the upside of the current great
recession is that it could drive a stake through the heart of the academic nostrum known as
EMH’’ .At the international organization of securities commissions annual conference held in
June 2009,the hypothesis took centre stage. Martin Wolf, the chief economics commentator
for the financial times dismissed the hypothesis as being a useless way to examine how
markets function in reality. Paul McCulley, managing director of PIMCO, was less extreme
in his criticism, saying that the hypothesis had not failed, but was ‘seriously flawed’ in its
neglect of human nature.

The financial crisis has led Richard Posner, a prominent judge, university of Chicago law
professor, and innovator in the field of law and economics to back away from the hypothesis
and express some degree of belief in Keynesian economics.Posner accused some of his
‘Chicago school’ colleagues of being ‘asleep at the switch’ saying that ‘the movement to
deregulate the financial industry went too far by exaggerating the resilience-the self healing
powers-of laissez-faire capitalism’. Others such as Fama himself, said that the hypothesis

15
held up well during the crisis and that the market were a casualty of recession not the cause of
it. These disagreements and lack of consensus among leading researchers in the field of EMH
suggest the need for more research work to add to the existing body of knowledge.

16
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