The main argument of the efficiency of market is that stock prices are always fairly valued. That means if new information released, a company’s stock price would react appropriately and change relative to other stocks in response to this new information. The efficient market hypothesis (EMH) is one of the most influential and widely accepted theories in finance.
Introduction – efficiency of market
The efficient market hypothesis (EMH) is a theory in financial economics, which states that markets are “informationally efficient” and consequently, current stock prices already reflect all available information.
The EMH states that all prices in the market are rational and efficient. Like the random walk theory, EMH has the assumption that the prediction of future’s price movements is not possible. So neither the use of technical analysis nor fundamental analysis can generate excess return.
Since the market always values the securities fairly, the hypothesis states it is impossible to generate return greater than the risk-adjusted return would justify. Consequently, the only way to beat the market performance is taking more risk. Nevertheless, there might be outliers in short term, but this is just a matter of luck.
Brief history
The efficient-market hypothesis is a milestone in the modern financial theory. The evolvement of idea goes back to random walk theory and the fair game model. The efficient-market hypothesis was developed independently by Eugene Fama (1965, 1970), a University of Chicago professor and Nobel Prize winner and by Samuelson (1965).
Eugene Fama published a review of theoretical and empirical research in his book “Efficient Capital Markets: A Review of Theory and Empirical Work,” in 1970, which expanded and refined his conception of the theory. Concerning the evidence, Fama said
The evidence for market efficiency is strong and (unusually in economics) the counter-evidence is modest.
He classified the efficient market hypothesis into three main variations.
What are the types of market efficiency?
According to the hypothesis, there are three types of market efficiency:
Weak Form of EMH:
The past information is already incorporated into security’s price, the time series information of financial variables are fully reflected (prices, dividends, interest, accounting results, etc.). The weak form has the assumption that the historical prices do not have influence on future price. Only new information affects the prices that have not yet been made public.
Semi-Strong of EMH: The security’s price fully reflects all public information (it is widely available to all market participants) including future’s publicly announced information.
Strong Form of EMH: Both public and private information reflects the current security’s price. In this form, not even insiders can benefit from unpublished information.
Investment strategy
The proponents, who believe in efficient market hypothesis, invest in low-cost, passive portfolio which reflects the market performance. Such investments can be the exchange-traded funds (ETFs) and index funds which trace the benchmark indexes.
In theory, the investors who believe in the market efficiency use neither technical nor fundamental analysis. Therefore, these analyses are undependable since the security price already reflects all available information (traded at its fair value), none of them can provide higher risk-adjusted returns.
Criticism – efficiency of market
The hypothesis refers to how efficient prices reflect all available information. There are some theoretical and empirical studies (authors such as Richard Thaler, Daniel Kahnemann, Werner De Bondt) which have published arguing against the EMH. These studies are mostly related to behavioral economists (how the individuals make market decisions) which explain the imperfections of financial market by combination of cognitive biases.
These studies suppose irrationality in investor’s behavior while information processing such as overreaction, information bias, framing effect, overconfidence etc.. Based on these cognitive biases, the investors can overreact to long-term negative news, predictably mispricing securities.
Conclusion
The efficient markets hypothesis (EMH) states that the market prices fully reflect all the information available. Since the prices are in equilibrium, price movements can happen as soon as new information published. So the theory leaves no room for investors to make excess profits. There might be outliers in short term, but this is just a matter of luck. To conclude, investors with full acceptance of the efficient market hypothesis chase market returns through low-cost, passive index investing.
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