Warren Buffett has been Chairman and CEO of Berkshire Hathaway, a general investment company, since 1965. Before that he headed various private investment partnerships. Over a period of 50 years, under Buffett’s leadership, these companies have outperformed broad market indices by an average of 11.16% per year.
Does the existence of abnormal returns made by the likes of Warren Buffett’s indicate market inefficiency or is this a black swan?
Required
You are required to write report on the efficient market hypothesis (EMH). Your report should outline the different forms of market efficiency and critically discuss the arguments for and against the EMH in addressing the above question. You are also required to choose a UK listed company of your choice and compare its last 5 year annual total shareholder returns to the FTSE index market returns. Highlight and explain any significant differences between the two.
Note-You are required to use graphs to showcase your returns and all data and calculations used should be in the appendix
Arguments for and against Efficient market hypothesis
In this report efficient market hypothesis (EMH) and its implications are defined and explained. Arguments for and against it are given and the monthly market return for Royal Mail Group (RMG) and FTSE 100 for the past 60 months have been calculated and analyzed.
Efficient Market hypothesis (EMH) is a theory of financial markets that states markets are efficient and this efficiency is the reason that share prices always incorporate and reflect all relevant information. It follows that this theory indirectly states that it is impossible to beat the market as assets in a market, by incorporating all the information, will be priced at their fair price and there will not be undervalued assets to buy or assets with inflated prices to sell.
Let’s more closely look at the consequences of efficient market hypothesis. By hypothesizing that market prices reflect all that there is to know about the value of existing instruments, the only thing that can change the price is new information and this new information cannot be anticipated because if it could, by the assumption of EMH it would already have influenced the price. From this it follows that the new information should be random and from this it would follow that the price changes for different instruments will be random as well.
From the previous discussion it follows that, to show the validity of efficient market hypothesis it is necessary to show that stock prices follow a random walk. For this, financial economists have performed two types of experiments. In one type research only look at the historical price movements and try to understand if the movement is systematically related to past movements. In the second type of experiment financial economists look at publicly available information and try to see if this information could have predicted the price movement. These results from both types of research show that asset prices follow random patterns (Eugene F. Fama, “Efficient Capital Markets: A Review of Theory and Empirical Work,”).
Arguments against efficient market hypothesis also exist. One of the earliest reported cases when the stock market seemed to not be efficient is called Small-Firm effect. Small-Firm effect is the result of many studies that show such firms have earned high returns over long periods of time even if the risk for such firms is taken into account. The small firm effect has been diminishing in recent years however it is still an anomaly that needs to be explained. Some of the attempted explanations are rebalancing of portfolios by institutional investors, tax issues, low liquidity of small-firm stocks, large information costs in evaluations of these small firms and inappropriate measurement of risk for small-firm stocks.
Another argument against efficient market hypothesis is the January effect. Stock prices tend to experience price rise from December to January and this is inconsistent with the random walk idea developed earlier. This effect also seems to have diminished in recent years. Some argue that this effect is observed because of tax issues which gives investors intensive to sell stock before the end of the year in December.
One other argument against efficient market hypothesis is simply the existence of investors that have shown profitable investments over a long period of time which according to EMH should be impossible and should just be a random coincidence. However, It is hard to imagine that Warren Buffet has been lucky all this time during his career.
Return on FTSE 100 and royal mail group
To continue the discussion let’s choose royal mail listed as RMG at FTSE 100. The graph for the price of this company together with the graph for the price of FTSE 100 for the past 60 months shows increasing growth for FTSE 100 and quite different periods for RMG. Calculating monthly returns for the past 60 months for RMG and for FTSE100 it’s noticeable that both graph have 1 extremum that implies that something has happened during that period that caused the price to change significantly which in turn has caused the return to go up significantly.
The reason that caused the shares of royal mail group to increase seems to have been the decision of government to support the company which led to investors buying this share.
The reason that has caused the spike in the return curve for the FTSE 100 is hard to explain and there does not seem to be a generally accepted reason for it.
In Conclusion, in general evidence for the EMH is more that evidence against it. It can also be argued that the reason it is possible to beat the market sometimes is that the information has not yet been incorporated into the price of an asset as this takes time and also not every investor sees such opportunities. So efficient market hypothesis perhaps holds true however when it does not it is because it is in the process, a process that required time not that it is not true in general.
References
Eugene F. Fama, “Efficient Capital Markets: A Review of Theory and Empirical Work,” Journal of Finance 25 (1970): 383–416.
Marc R. Reinganum, “The Anomalous Stock Market Behavior of Small Firms in January: Empir- ical Tests of Tax Loss Selling Effects,” Journal of Financial Economics 12 (1983): 89–104;
Jay R. Ritter, “The Buying and Selling Behavior of Individual Investors at the Turn of the Year,” Journal of Finance 43 (1988): 701–717;
Richard Roll, “Vas Ist Das? The Turn-of-the-Year Effect: Anomaly or Risk Mismeasurement?” Journal of Portfolio Management 9 (1988): 18–28.
Appendix
RETURN of FTSE 100
RETURN OF ROYAL MAIL GROUP
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