“Ovidius” University Annals, Economic Sciences Series

Volume XXI, Issue 2 /2021

A Critical Survey on Efficient Market Hypothesis (EMH), Adaptive

Cristi Spulbar
University of Craiova, Faculty of Economics and Business Administration, Romania
[email protected]
Ramona Birau
University of Craiova, Doctoral School of Economic Sciences, Romania
[email protected]
Lucian Florin Spulbar
University of Craiova, Faculty of Economics and Business Administration, Romania
[email protected]

Abstract

The fundamental objective of our research study is to provide a critical analysis on Efficient
Market Hypothesis (EMH), Adaptive Market Hypothesis (AMH) and Fractal Markets Hypothesis
(FMH) considering their impact on stock markets behavior. Efficient Market Hypothesis is one of
the pillars of modern finance and it is built on the paradigm that any publicly information can be
considered as available for all financial investors, stock market participants or other actors in
financial markets, and consequently asset prices always integrate and reflect all relevant
information. Adaptive Market Hypothesis is based is a more recent theory whose theoretical
architecture includes evolutionary principles. On the other hand, the Fractal Market Hypothesis is
focused on the concept of the stock market liquidity, considering the fact that Efficient Market
Hypothesis completely ignores this major aspect. Moreover, a liquid stock market represents a stable
market which has significant implications at the investment level. Past financial evidence has shown
that short-term price changes exhibit the obvious tendency to be more volatile compared to long-
term price trends.

Key words: Efficient Market Hypothesis (EMH), Adaptive Market Hypothesis (AMH), Fractal
Markets Hypothesis (FMH), stock market, Random Walk Hypothesis (RWH), chaos theory
J.E.L. classification: D53, E44, G1, G4

1. Introduction

This research paper aims to investigate most relevant aspects regarding Efficient Market
Hypothesis (EMH), Adaptive Market Hypothesis (AMH) and Fractal Markets Hypothesis (FMH)
considering their effects on stock markets behavior. Efficient Markets Hypothesis is not a falsifiable
theory since frames the behavior of stock market asset prices under certain conditions, including the
concept of informational efficiency. Stock market efficiency includes three main categories, such as:
strong form efficiency, semi strong form efficiency and weak form efficiency. According to Malkiel
(2003) an efficient market involves certain limitations that affect investment behavior given that it
does “not allow investors to earn above-average returns without accepting above-average risks”.
In literature, the paradigm of efficient market hypothesis is assimilated in close connection with
the random walk theory. As a pioneering theoretical approach, Kendall (1953) argued that “stock
price fluctuations are independent of each other and have the same probability distribution”.
Technically, every further asset price changes actually means just random departures from previous
prices. In other words, Fama (1965) highlighted important aspects of random walk theory and argued
that: “the future path of the price level of a security is no more predictable than the path of a series

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of cumulated random numbers”. Furthermore, Fama (1970) discussed the matter of efficient capital
markets and suggested that the perfect scenario targets a capital market “in which prices provide
accurate signals for resource allocation”.
On the other hand, Adaptive Market Hypothesis (AMH) tends to perceive Efficient Market
Hypothesis (EMH) as a theorized utopia that is impossible to apply in economic practice. In case of
Adaptive Market Hypothesis (AMH), it is important to discuss about optimal dynamic allocation,
but also relative efficiency. Moreover, Fractal Market Hypothesis represents another alternative to
the concepts promoted by Efficient Market Hypothesis. Konstantinidis et al. (2012) have developed
a critical empirical research (by comparison) between the main principles of Efficient Market
Hypothesis and Behavioural Finance Theory, and argued that: “investing rationality and efficient
market processes over time contradict investors’ psychology, biased behavioral rules and market
bubbles”.
Extreme events such as the global financial crisis (GFC) significantly affects the development of
the financial sector. For instance, the recent COVID-19 pandemic caused severe lockdown in most
countries of the world, whether they were developed, emerging or underdeveloped, so affected the
performance of all the sectors of the economy, including financial system (Batool et al., 2020).
However, Spulbar et al. (2020) consider that global financial liberalization generates a lower impact
on emerging economies compared to the case of developed economies. Consequently, it is very
important to have a theoretical foundation that provides efficient solutions, especially in times of
financial turmoil.

2. Literature review

Eugene Fama is a Nobel laureate in Economic Sciences, with significant contributions in the field
of financial markets. In literature, Fama is also considered the father of Efficient Market Hypothesis
which represents the quintessence of modern finance theory. According to Fama (1965): “The main
conclusion will be that the data seem to present consistent and strong support for the random-walk
model. This implies, of course, that chart reading, though perhaps an interesting pastime, is of no
real value to the stock market investor.” Fama (1970) also stated as “definitional statement” that: “A
market in which prices always fully reflect available information is called efficient”, but this
condition “has no empirically testable implications”.
In another train of thoughts, Fama (1976) suggested that: “An efficient capital market is a market
that is efficient in processing information considering the fact that in the case of an efficient market,
prices ‘fully reflect’ available information”. In order to support the validity of market efficiency
hypothesis, Fama (1998) argued that: “anomalies are chance results, while apparent overreaction to
information is about as common as underreaction”. In addition, Malkiel (2003) examined the linkage
between the important conditions of predictability and efficiency in order to provide a viable
explanation for possible investment opportunities and promoted the principles of Efficient Markets
Hypothesis even in the light of the following issues: “if many market participants are quite
irrational” and “if stock prices exhibit greater volatility than can apparently be explained by
fundamentals”.
Samuelson (1965) has made a significant contribution to disseminating the concept of market
efficiency and argued that financial asset prices swing using a random pattern since future
information is unpredictable and the changing price of financial assets also follows a random
dynamics. Moreover, Sewell (2011) investigated relevant aspects regarding Efficient Market
Hypothesis and concluded that “the definitional ‘fully’ is an exacting requirement, suggesting that
no real market could ever be efficient, implying that the EMH is almost certainly false”.
Fractal Market Hypothesis represents a very complex theoretical structure. Peters (1994)
suggested that: “in fractal time, randomness and determinism, chaos and order coexist”, but also
revealed that ” It has been difficult to reconcile randomness and order, chance and necessity, or free
will and determinism”.

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3. Research methodology

The research methodology of this research paper includes a theoretical approach built on
qualitative analysis. Brown (2020) analyzed in an exhaustive manner the implications of Efficient
Market Hypothesis and concluded that it is very necessary as a price to be characterized by an
adequate level of noise or inefficiency in order to enable the compensation of information production.
For instance, Noda (2016) investigated the existence of Adaptive Market Hypothesis in case of
Japanese stock market using a time-varying model, and identified that the degree of efficiency for
selected stock markets changes over time, while empirical findings confirm Adaptive Market
Hypothesis for the higher qualification stock markets. Fractal Market Hypothesis provides a different
perspective compared to Efficient Market Hypothesis. It is based on chaos theory.
Lo (2005) provided a very interesting approach to Adaptive Market Hypothesis, considering the
influence of evolutionary principles, such as it involves the fact that “the degree of market efficiency
is related to environmental factors characterizing market ecologies such as the number of
competitors in the market, the magnitude of profit opportunities available, and the adaptability of
the market participants.” As a representative approach applied for testing the Adaptive Market
Hypothesis, Lim and Brooks (2011) suggested certain criteria regarding market efficiency, which
should be varying through time, and on the other hand should be dependent on particular market
conditions such as: financial crises, market crashes, stock bubbles and others.

4. Findings

Malkiel (2003) pointed out the fact that news is implicitly unpredictable by its very nature so as
a consequence the price changes determined in this way have to be unpredictable, but also random,
or in other words, “prices fully reflect all known information”. According to Fama (1965) “in an
efficient market, on the average, competition will cause the full effects of new information on intrinsic
values to be reflected instantaneously in actual prices”. In a previous research study, Malkiel (1973)
argued that if „a blindfolded chimpanzee throwing darts at the Wall Street Journal could select a
portfolio that would do as well as the experts” focusing on the idea that efficient markets do not
allow financial investors to earn (gain) above-average risk-adjusted stock returns.
Spulbar and Birau (2018) investigated weak-form efficiency for a cluster of emerging capital
markets, such as: Romania, India, Poland and Hungary considering the argument that stock market
security prices always incorporate and reflect all relevant information. The empirical findings
demonstrated that efficient market hypothesis has been rejected even in the case of weak-form
efficiency for the sample period January 2000 to July 2018.
Trung and Quang (2019) examined the implications of Adaptive Market Hypothesis based on a
case study for the Vietnamese Stock Market using certain autocorrelation tests such as: AVR test,
AP test, GS test, but also a time-varying autoregressive framework. The empirical findings revealed
that the behavior of Vietnamese stock market complies with Adaptive Market Hypothesis, while the
market inefficiency has been considerable during previous financial crises, such as the period 2006–
2007, but also 2011.
Lo and MacKinlay (1988) have conducted a solid empirical study in order to identify the reasons
why stock market asset prices do not actually follow a random walk pattern and pointed out that:
”… the common misconception that the Random Walk Hypothesis is equivalent to the Efficient
Markets Hypothesis…” considering the economic implications of the empirical findings. However,
Jegadeesh and Titman (1993) performed certain empirical studies applying momentum effect
strategies which can determine the existence of abnormal stock returns. Spulbar et al. (2019) argued
that considering the financial modeling effect of efficient markets hypothesis results that if we
consider normal distribution, the skewness is naturally null.

5. Conclusions

This research paper provides a very well structured and documented comparative conceptual
overview. It is concluded that Efficient Market Hypothesis (EMH), Adaptive Market Hypothesis
(AMH) and Fractal Markets Hypothesis (FMH) represent essential paradigms in modern financial

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theory, with significant implication on understanding stock markets behaviour. Kemp and Reid
(1971) examined the empirical evidence on random walk hypothesis which claims that the changes
in financial share prices are independent, so that it generates a random walk in price levels and argued
that the dynamics of share price is “conspicuously non-random”. Fractal Market Hypothesis
considers that financial investors will not react immediately to the information they receive, while
their reaction will also be distinct. Fractal Market Hypothesis is focused on the idea of stock market
liquidity, despite the fact that Efficient Market Hypothesis does not even mention this extremely
important concept, especially in the context of globalization and financial liberalization.
Synthetizing, a liquid stock market is considered to be a stable market and this is very important in
the financial investment environment.
Lo (2004) proposed an innovative perspective using the concept of Adaptive Markets Hypothesis
(AMH) as an evolutionary framework, but also cognitive neurosciences insight in understanding
economic linkages. Wilson (1975) defined the new concept of sociobiology a the “systematic study
of the biological basis of all forms of social behavior”, that is, including the behavior of financial
markets. Thereby, Lo (2004) highlights a number of psychological traits of human behavior, such as:
altruism, fairness, kin selection, language, mate selection, religion, morality, ethics, and abstract
though and suggest that this complete reconciliation of Efficient Markets Hypothesis based on its
behavioral selection choices implicitly generates an innovative synthesis called Adaptive Markets
Hypothesis.

6. References

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