Reflections on theories of market efficiency

• Date: 01 November 2019
• DOI: http://doi.org/10.1002/pa.1947
• Author: Malvika Nandlal Chhatwani
• Published date: 01 November 2019

PRACTITIONER PAPER

Reflections on theories of market efficiency

Malvika Nandlal Chhatwani

Department of Accounting and Finance, Indian

Institute of Management Indore, Indore, India

Correspondence

Malvika Chhatwani, Department of Accounting

and Finance, Indian Institute of Management

Indore, Prabandh Shikhar, Rau‐Pithampur Road

Indore, Madhya Pradesh 453556 India.

Email: malvika.chhatwani@gmail.com

Market efficiency is determined by how efficiently markets capture the information.

Efficient markets can capture and incorporate all the available information into stock

prices within no time. It means market prices traded are the actual prices of shares.

There have been many theories trying to debate about how to determine market effi-

ciency. If markets are efficient, there is no scope for investors to earn abnormal

returns on the investments. In that case, investments in markets would not provide

any additional returns. There have been many debates and theories on the topic of

market efficiency. Postmodern portfolio theory (PMPT) came into existence after

almost 40 years of the modern theory of portfolio given by Henry Markowitz. Both

the theories give a risk–return framework for decision making and there are many

conflicting aspects of market efficiency. I try to address this issue in this paper that

raises concerns for the investor as to which markets are called efficient and what con-

tributes to market efficiency, as denoted in modern portfolio theory (MPT) and post

modern portfolio theory (PMPT).

1|INTRODUCTION AND RELATED

LITERATURE

Henry Markowitz laid the foundation of theory of market efficiency

and proposed modern portfolio theory. He offered the formal risk

and return framework to measure risk aversion of the investor. To

measure risk and return in numbers and make it quantitative, Marko-

witz gave a portfolio selection formula which is a two‐stage process.

In the first stage, it begins with observation and experience, whereas

the second stage includes beliefs of investors about the future perfor-

mance. This stage is based on the perception of the past as well as

future expectations. The second stage then leads to the portfolio

selection. Investors have historical data, and they expect discounted

future cash flows to equate their future returns.

Earlier view on stock price movement was believed to be unpre-

dictable. Researchers in the early 20th century believed that stock

prices follow a random walk pattern (Bachelier, 1900). After this first

notion about stock prices unpredictability, there was no evidence on

the predictability of prices in the market. This theory was picked up

fifty years later by Kendall (1953). He proposed that stock prices

follow a random walk in the market and one can by no means

predict the future movement of the prices. There is no relation

between stock prices at time tand at time t+ 1 hence studying

and predicting prices is impossible. Researchers such as Samuelson

(1965) and Mandelbrot (1966) emphasized on the notion given

by Kendall that there is no relation between two consecutive

stock prices.

It was in 1970 when Fama came up with market efficiency theory

(Fama, 1970). He suggested that markets can be efficient in three

forms: weak, semi‐strong, or strong. The efficiency of markets

depends upon their capability of capturing available information into

stock prices. He associated relevance of past information, public infor-

mation, and private information with three levels of market efficiency.

After his article in 1970, market efficiency theory became popular and

accepted. In support of market efficiency theory by Fama, Professor

Jensen writes in 1978 that market efficiency has strong theoretical

foundations (Jenson, 1978). Further, he raised concerns relating to

measurement problems and joint hypotheses problems arising in mar-

ket efficiency.

Postmodern theory of portfolio (PMPT) came into existence after

almost 40 years of the modern theory of portfolio (MPT) given by

Henry Markowitz (Rom and Ferguson, 1994). Both the theories give

a risk–return framework for decision making. As there are no theories

without limitations, modern portfolio theory given by Markowitz

Received: 28 February 2019 Accepted: 23 March 2019

DOI: 10.1002/pa.1947

J Public Affairs. 2019; :e1947.

https://doi.org/10.1002/pa.1947

© 2019 John Wiley & Sons, Ltd.

wileyonlinelibrary.com/journal/pa 1of519