Testing the market efficiency by mean absolute deviation

Abstract

Purpose

Numerous articles have been written to prove or to disapprove the hypothesis of market efficiency. The purpose of this paper is to apply the forecast accuracy measure, mean absolute deviation (MAD), to check the validity of the hypothesis.

Design/methodology/approach

Forecast accuracies from applying different simple moving average methods to independently identically distributed (i.i.d.) or near i.i.d. normal time series are assessed by MAD. When moving period n is greater than m, then the mean of the MADs from the MA with n moving periods will be smaller than the mean of the MADs from the MA with m moving periods.

Findings

In this study, when different MAs are applied to four near i.i.d. finance time series from Fama’s papers, the MAD cannot distinguish the differences among MA methods with various moving periods. This contradiction implies that the four finance time series in Fama’s papers may not be i.i.d and implies that the market is not efficient.

Research limitations/implications

The finding is only based on simulation and four near i.i.d. time series studied in Fama’s papers in 1965 and 1970.

Practical implications

The study shows that that the differences of the rates of returns from Johns Manville, Goodyear, Owens Illinois, and General Electric studied are not i.i.d. and that the market is not efficient. It refutes what Fama (1965, 1970) has claimed.

Social implications

When the market is not efficient, investors may gain profit from the market.

Originality/value

Based on the literature review, this is the first study to use the forecast accuracy measure, MAD, for market efficiency.

Citation

Ren, L. and Ren, P. (2017), "Testing the market efficiency by mean absolute deviation", Benchmarking: An International Journal, Vol. 24 No. 7, pp. 2049-2062. https://doi.org/10.1108/BIJ-06-2016-0096