What are some theoretical explanations for deviations from the efficient market hypothesis?

Question

According (the semi-strong form of) the efficient market hypothesis, the price of an asset should reflect all publicly available information about the 'fundamental value' of that asset. The reasoning is that if there is some public information that suggests the price is below the fundamental value then people will have an incentive to act on this information and buy more of the asset. This increase in demand will cause the price of the asset to rise, closing the original price-value discrepancy.This reasoning seems intuitively plausible, but significant price-corrections during the recent recession seem to suggest that markets had systematically priced in a manner inconsistent with underlying fundamentals. What academic theories (i.e. published or in working papers) have been advanced (and by whom) to explain why the efficient market hypothesis might fail? Is there much of an empirical consensus on the validity of the efficient market hypothesis in the literature?

Answer 1

Hello!

Many great investors routinely exploit inefficiencies in market pricing to take significant profits. They believe that if prices were perfectly efficient, that would be impossible. Proponents of EMH argue that it is possible to make profits by trading on the market, but it is impossible to make abnormal profits in violation of the EMH. I can certainly give you a real-world examples as opposed to a literature if you choose to consider it. You may consider the following scenarios where EMH most likely does not hold.

1. Many Small Cap Stocks that are generally not invested by big institutions. Big institutions have huge amount of capital and there is a limit on how much of a particular stock they can invest in without without controlling the whole company. In cases like this, big institutions tend to stay away from small cap stocks. As a result small cap stocks tend to get less following from analysts. Now if you do your research and think a particular small cap firm is undervalued, you can buy the stock. When the company starts to get attention, everyone will jump on board and drive the price up. This is just one example.
2. Recession/Correction: As you may already know that during recession/correction, many great companies lose their market value. If you have access to capital, you can certainly take advantage of this opportunity and buy the stocks and wait for the price to go up. There are hundreds of real world example of this.
3. Regardless of the investment merit of the stocks, certain group of stocks may be sold off by funds when they don't fit the charter of the fund. As a result, a window of undervaluation is created that can greatly reward investors.

Now there are many example of this, but I wanted to share a few with you. Hope this helps!