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On the Efficient Market Hypothesis – Illuminating Simulation and Criticism of Technical Analysis

June 21, 2012

According to the efficient market hypothesis stock prices are essentially random and reflect all publicly available information related to the stock. Price movements are caused by new information which, per definition, is unknown beforehand. Hence there is no scope for profitable speculation.

The following simulated dice game gives some visual support to the claim that changes in stock prices are purely random (this MATLAB program let you redo my simulation). Rules of the game: One dollar is won given an even number and one dollar is lost given an odd number. The y-axis displays total win/loss and the x-axis shows number of games (10 000 in total).

Dice Game

The graph remind you of a financial chart, does it not? For example consider Stockholm all-share index (OMX) for the last three years.

Stockholm OMX

The random movements seem to exhibit trends due to persistence of random shocks — this mislead people to believe in “technical analysis” of stocks, arguing past prices helps you predict future prices — but there is (of course) no such rationale when a die is being tossed.


From → Finance

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