EFFICIENT MARKETS HYPOTHESIS AND OTHER THEORIES OF PRICING IN FINANCIAL MARKETS

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Efficient Markets Hypothesis and other theories of pricing in financial markets
Efficient market hypothesis (EMH) is a theory that emerged in the 1960s. It states that it is difficult to predict the market since the price has been set and reflect the current market conditions. It is a disputed and controversial theory. The theory is comparable to other theories of pricing in financial markets. Several strengths and shortcomings emerge through comparison with other theories of pricing (Blinder, et al., 2012). EMH states that no stock is a better buy when compared to others. It is the conclusion that leads to random choices. It is a vital tenet of finance theory. The EMH theory has a basis in other finance theories. It follows the classical theory of asset prices. To determine the connection, a situation where stocks are considered based on good deals. According to the EMH theory, these stocks are worth more than their relative prices. The worth of a stock is the present value of the expected dividends. In this regard, an individual will buy stocks at prices that are below this level. In essence, this is buying stocks that are undervalued assets (Kapil, 2011).
Classical theory
The classical theory follows the belief that the price of a stock is equal to the best estimate of the stock’s value. This equality means that the undervalued stocks are not real. It is futile to determine or find them. A stock price always equals the present value of expected dividends. Under the EMH, every instance that you sell or buy securities, you are being involved in a game of chance. It is not a skill gained through learning. If the markets are current and efficient, then the set price is a reflection of all the necessary information. In this regard, it is impossible to buy stocks at a bargain price (Toporowski, 2010). Many people oppose the EMH theory, especially by technical analysis. The argument against EMH is that a large number of investors base their expectations on past earnings, prices, records and other indicators. Since stock prices relate to the exceptions for the investors, it is only applicable that future price influence stock prices.
Evidence collected in the past ten years suggest that there is an excess volatility in stock markets. Stock prices regularly change from their fundamental values. The empirical results have led to several alternative theories to detail the observed volatility. It includes fads and noise trading. For instance, the stock market crash that occurred in 1987 led economists to reassess the validity of the EMH (Alexander & Moloney, 2011). An implication of the EMH is that stock price tends to follow a random walk. In essence, the change occurring in the stock prices is difficult to predict. If, based on the information available, a person can determine that the stock price by 10% tomorrow, then the stock market must be failing to incorporate that information (Collum, 2014).
To understand the EMH, changes in the stock market should undergo analysis. When picking stocks, the investor will identify those whose prices are bound to rise in future. In this regard, it is much easier to earn capital gains when the increase occurs. If the forecast is right, then the returns will exceed those in a random selection of stocks (Toporowski, 2010). On the other hand, the EMH says that such a strategy, as applied to the classical theory, will not work. A stock price is a means to show the expectations of a firm on its dividends. It relies on all necessary information about the firm. In order the information to be useful, it must be a surprise. For instance, the recent earnings announcement released by an organization was higher than anticipated. Releasing this information in advance will mean that the expected dividends will include this information (Benner, 2013). In this regard, it is impossible to predict prices. Since surprise information tends to affect stocks, changes in these prices are unpredictable. In statistical terms, each price follows a random walk.
Behavioral decision theory
The tendency of the stock market to react has been of importance of many studies. It emerged from the behavioral decision theory as a means to understand pricing within the financial markets. In this regard, predicting efficient markets based on a rational choice leads to wrong conclusions (Toporowski, 2010). Even though many people are subject to behavioral biases from time to time, the market forces will always act to return prices back to rational levels. This belief relies on the assumption that market forces are powerful enough to overcome any emerging behavioral bias. The irrational beliefs are not powerful enough to change the capacity of arbitrage capital that takes advantage of such irrationalities (Shiller, 2003). An empirical issue cannot find a theoretical conclusion. Indeed, testing has to occur through statistical analysis and measurement. According to the classical reference by Kindle Berger, the forces of irrationality can easily overwhelm the forces of arbitrage capital for months or years (Michelucci, 2013).
Behavioral finance is a new school of thought. People make systematic cognitive errors when creating expectations. One such error that can detail the overreaction in stock prices is the representative heuristic. In this case, people try to determine trends even when there is none. It leads to a mistaken idea that future patterns will follow those in the past. Moreover, determining the momentum in stock returns is through consideration of the anchoring process (Fama, 1985). There is a tendency to overweigh initial beliefs while underweight the importance of new information. It emerges from the momentum observed over immediate horizons until a point where operation occurs. It does not mean that it is an easily exploitable trading mechanism. The point where the momentum ends and overreaction begins is never easy to define until after it has occurred.
There has been contention on the view that stock price systematically overact. It has emerged from a behavioral interpretation, which leads to a similarity with the views held by EMH. Stocks earn bigger returns in cases of difficult economic conditions. During this time, the default risk premiums and interest are high and capital is scarce. High-interest rates lead to price reductions from the start. Once the business conditions improve, the prices recover. In comparison, EMH follows the belief that cognitive failures of certain individuals will have minimal impact on stock markets (Frankfurter, 2007). Misplaced stocks should attract rational investors who sell overpriced and buy underpriced stocks.
In case rational traders recognize a mispricing, the market will not necessarily correct itself. Instead, the change will come after the mispricing. From that point forward, noise traders begin to lose confidence in the trend. Moreover, a rational trader will also act because of the additional risks that notice traders have introduced. Even though traders act swiftly on their information, mispricing will continue, as there are few parties for low-risk arbitrage trading (Graham, et al., 2010). For instance, how should a trader respond to the emergence of the internet-based stocks in the late 1990s? In this scenario, the available stocks were hard to short sell. Even if it could be possible, a fully rational and well-informed short seller encountered an additional risk that noise traders will move the prices way from the fundamentals (Michelucci, 2013).
The adaptive markets hypothesis
The adaptive market hypothesis (AMH) is a theory of pricing where a biological perspective applies in the analysis of the financial markets. It follows an evolutionary framework whereby investors, institutions, markets and instrument evolve and interact dynamically according to the law of economic selection. In this regard, the financial agents adapt and compete, but it is not necessarily in an optimal fashion. The theory has its origins in the discipline of evolutionary psychology (Mankiw, 2009). It considers the application of the principles of reproduction, natural selection and competition to social interactions. It leads to an understanding of certain kinds of human behavior. It raised controversy as supporters such as E.O. Wilson (1975) consider it applicable in financial and economic contexts (Fama, 1985). It becomes possible to compare EMH with AMH as a means to synthesize pricing in the markets. Biological arguments are influencing in understanding pricing. Arithmetic applies to accounting natural resources, whereas populations increase following geometric rates. In essence, both these factors lead to dire economic consequences. Capitalism, entrepreneurs, and business cycles suffer from the process of pricing (Schmidlin, 2014).
The beauty contest analogy by John Maynard Keynes is also an alternative theory of pricing in financial markets. It is comparably similar to EMH. It states that each stock analyst does not recommend the stocks that they think are the best. Instead, the choose stocks where they think that a large number of analysts prefer. According to this theory, stock prices depend on speculation and not economic fundamentals. After an extensive period, prices under the control of speculation will involve those that exist based on economic fundamentals (Malkiel, 2003).
Evolutionary concepts are influential in understanding financial contexts. For instance, natural selection has an impact on future makers. Traders who are overconfident in a competitive market face a risk in the long-term respect. The financial market is similar to an ecosystem. Speculators are carnivores, dealers are herbivores and distressed investors and floor traders are decomposers. This theory goes against the beliefs of EMH that states that there is an equilibrium in markets and pricing. In essence, the theory shows that equilibrium rarely realized. In this regard, the market dynamics can be better explain the evolutionary process (Worthington, 2009).
The current context of EMH considers the individual consumer. Contrary to the neoclassical beliefs that individuals seek to maximize expected utility and have rational beliefs, and evolutionary perspective follows claims that are more modest. Individuals are organisms that have to be honed. It occurs through a long period where natural selection maximizes the genetic material. This perspective can apply to understanding economic behavior. Behavior is not necessarily inborn or intrinsic. It depends on the particular environment in which an individual exists. It also evolves by natural selection. It means that natural selection operates on both social and cultural norms and not just genetic material (Benner, 2013). In essence, activities within the market affect how traders determine pricing and their rational expectations.
Stock returns and their impact on the economy did not receive attention before the 1950s. Few investors knew the role of stock markets in allocating capital. This oversight is because of several factors. During the Great Depression and post-World War II, economists had the belief that government-directed investment should be the norm. People view stock markets as casinos due to the speculative nature of its operations. Moreover, the emergence of modern corporations was a new development. Such corporations have an insatiable need to raise funds for capital. Utilizing the stock market is the best strategy to raise the required funds. The advent of computers in the 1950s led to increased attention by academic researchers. It made it easier to carry out an empirical analysis of large data sets (Kapil, 2011).
The EMH has been influential in understanding the pricing of financial markets. Despite its applicability in many areas of the economy, other theoretical frameworks have emerged to show its limitations. Several theories have emerged order to detail pricing in financial markets. Theories such as the classical, behavioral decisions and adaptive markets are comparable to EMH. They determine its strengths and shortcoming. These theories provide practical insights in understanding pricing in financial markets. EMH has been a controversial theory. Despite the lack of consensus in industry and academia, the ongoing research and dialog has proved vital in understanding the economic structure of financial markets. Many investors seek to achieve the highest returns possible. In reality, this has been difficult to achieve. The market has intense competition, leading to rapid price adjustments based on new information. The EMH is vital in understanding price movements in securities markets.

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