Malkiel’s fame revolves around easy steps to larger returns. “Random walk in the stock market means that short run changes in stock prices cannot be predicted.” He contends this term is an obscenity on the Wall Street, thus disproving thousands of authors and theorists who believe they have the proven ability to beat the market (2003). One main observance from literature today regards whether or not stock prices systematically overreact.
The seminal study in this area comes from DeBondt and Thaler (1985), which appears to show that past winners tend to offer negative abnormal returns during the post-formation period, with past losers offering positive abnormal returns in this same period.
They use Keynes’ description of seemingly absurd fluctuations in the market following makeshift worries and gossip from the business world. Pre- and post-formation periods range from one to five years.
It is further reported that stocks have ‘overreacted’ the most where the pre-formation period is longer, and hence where the abnormal returns are more extreme, with a tendency to exhibit a correspondingly greater ‘correction’ during the post-formation period (DeBondt & Thaler 1985).
Peter L. Bernstein responds to DeBondt and Thaler with condescension. While finding the, “reasoning in their paper to be convincing and their test results most impressive,” he states that the conclusions and its write-up are flawed from the onset.
They begin, according to Bernstein, by stating how efficient the market is, then use the remainder to go against that ideal. Bernstein posits that the market is highly efficient. He believed that once investors gained a hold on the long-run inefficiencies, they would cease to exist, thereby eliminating them altogether (1985).
Questions emanating from this involve whether results obtained (1) can be explained by a risk-premium story (DeBondt & Thaler 1985) (2) are due to methodology mining or data mining (Fama 1991), or (3) are due to biases in the methodology used (Clare, Priestley & Thomas 1997).
The accumulating evidence suggests that stock prices prove predictable with a fair degree of reliability. Two competing factions explain such behaviour. Proponents of EMH [(Fama and French 1995), (Goodacre, Bosher & Dove 1999), (DeBondt & Thaler 1985)] maintain that such predictability results from time-varying equilibrium expected returns generated by rational pricing in an efficient market that compensates for the level of risk undertaken.
Critics of EMH [(Al-Loughani & Chappell 1997), (Jasic and Wood 1994), (Clare, Priestley & Thomas 1997), (Malkiel 2003)] argue that the predictability of stock returns reflects the psychological factors, social movements, noise trading, and fashions or “fads” of irrational investors in a speculative market. The question about whether predictability of returns represents rational variations in expected returns or arises due to irrational speculative deviations from theoretical values has provided the impetus for fervent intellectual inquiries in the recent years.
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