Efficient market hypothesis and low risk anomaly

Abstract

High-Risk stocks have offered a combination of relatively high risk and high losses. We decomposed the stocks into micro and macro components for identification of risk and returns relationship, and the existence of efficient market hypothesis. The micro component comes from the selection of stocks at individual beta level. The macro component comes from the selection of stocksat industry beta level. Micro component contribute to the anomaly while macro component does not contribute to the anomaly, as results of micro component were more conclusive and significant while results of macro component were not conclusive as mostly they were insignificant. For empirical analysis, this study uses the Malcolm and Baker methodology (Malcolm Baker, 2014). Accordingly a sample of 336 stocks from 33 different sectors listed on the Karachi stock exchange is used to form portfolios in quintiles i.e. stock base portfolios, cap-weighted portfolios, and industry base portfolios. KSE.100 index is used as a proxy for the market portfolio. Monthly data on all the variables was obtained over sample period January 2004 to December 2014 and 2015. Monthly Treasury bills rate is used as a proxy for the risk free rate. Panel regression technique is used for empirical analysis in line with the Malcolm-Baker methodology. The findings of the present study on the empirical validity of the traditional CAPM at micro component selection of portfolios is that there exists high risk anomaly, while at macro level selection of industry base portfolios mostly the results are inconclusive as mostly intercept term is insignificant. The findings of the study suggest that there is no statistically significant risk premium for systematic risk as defined in traditional CAPM and in efficient market hypothesis over the full sample period. In contrast to the findings of traditional CAPM and efficient market hypothesis the risk premium is negatively and statistically significant mostly at 1% which shows that there exists high risk anomaly at KSE.100 index i.e. the higher the risk the higher will be the losses. Based on the major findings of the present study, it is concluded that there is lack of fundamental evidence to validate traditional CAPM and efficient market hypothesis of high risk and high returns, in the KSE.100 index. Hence it may be implied that the KSE.100 index is an inefficient equity market and does not provide a fair risk-return premium, rather it provide negative riskreturn premium. It implies that any diversification based on the underlying theory of traditional CAPM investigated in the present study may result in poor investment performance and losses. Investors should give more attention to obtain and analyze information that is adequate, accurate and timely. The stock markets in Pakistan should be demutualized to reduce the role of insider trading, private information as well as speculation and manipulation of the market by few influential market players.