In the last post, I talked about the three main categories of the Efficient Market hypothesis. In this post I’ll talk more about the weak form efficiency. To recap, the weak form efficiency basically says that current prices, reflect all past prices’ information. This means that techniques such Technical Analysis and Chart Reading can’t work.
Consider a game of heads and tails. If you get heads, you win 3.5% on your investment. Otherwise, you lose 2.5%.
If you could play this game only once a day, how does such an investment look in the long run?
This is a very compelling graph. It shows that what people consider a trend may actually be a random event.
Studies have shown that there is no correlation between day to day returns. Could it be that trends do not exist and the market just follows what is called a random walk?
Although the above looks compelling, there are persistent statistical anomalies (although most are fading) that put doubts in the market efficiency. One, such as buying winners and selling losers, was already discussed. Another one is the weekend effect.
Studies have tried to determine the excess returns in different days of the week. A good speculation of the result would have to indicate higher returns on Mondays. This is because Monday returns would have to compensate for risk of having the stocks for the weekend. Moreover, we need to be compensated for the loss of alternative interest rate in the weekend. What were the results then?
As you can see, Monday returns are actually lower! Although not lower enough to be able to make money, so the weak efficiency can still be a valid claim. You could still claim that the rationality hypothesis is not obsolete though, as seen in the above results.
In the next post, I’ll discuss in more detail the semi-strong efficiency. So stay tuned for coming updates.
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