Efficient Market Hypothesis - Financial Management, Finance, Corporate Finance, Economics Concept

Efficient Market Hypothesis

A market theory that evolved from a 1960's Ph.D. dissertation by Eugene Farma, the efficient market hypothesis states that at any given time and in a liquid market, security prices fully reflect all available information. The EMH exists in various degrees: weak, semi-strong and strong, which addresses the inclusion of non-public information in market prices. This theory contends that since markets are efficient and current prices reflect all information, attempts to outperform the market are essentially a game of chance rather than one of skill.

The weak form of EMH assumes that current stock prices fully reflect all currently available security market information. It contends that past price and volume data have no relationship with the future direction of security prices. It concludes that excess returns cannot be achieved using technical analysis.

The semi-strong form of EMH assumes that current stock prices adjust rapidly to the release of all new public information. It contends that security prices have factored in available market and non-market public information. It concludes that excess returns cannot be achieved using fundamental analysis.

The strong form of EMH assumes that current stock prices fully reflect all public and private information. It contends that market, non-market and inside information is all factored into security prices and that no one has monopolistic access to relevant information. It assumes a perfect market and concludes that excess returns are impossible to achieve consistently.

The efficient market hypothesis is associated with the idea of a “random walk,” which is a term loosely used in the finance literature to characterize a price series where all subsequent price changes represent random departures from previous prices. The logic of the random walk idea is that if the flow of information is unimpeded and information is immediately reflected in stock prices, then tomorrow’s price change will reflect only tomorrow’s news and will be independent of the price changes today. But news is by definition unpredictable and, thus, resulting price changes must be unpredictable and random. As a result, prices fully reflect all known information, and even uninformed investors buying a diversified portfolio at the tableau of prices given by the market will obtain a rate of return as generous as that achieved by the experts. 

So is the market really efficient?

An important debate among stock market investors is whether the market is efficient – that is, whether it reflects all the information made available to market participants at any given time. The efficient market hypothesis(EMH) maintains that all stocks are perfectly priced according to their inherent investment properties, the knowledge of which all market participants possess equally. At first glance, it may be easy to see a number of deficiencies in the efficient market theory, created in the 1970s by Eugene Fama. At the same time, however, it’s important to explore its relevancy in the modern investing environment.

Financial theories are subjective. In other words, there are no proven laws in finance, but rather ideas that try to explain how the market works. Here we’ll take a look at where the efficient market theory has fallen short in terms of explaining the stock market’s behavior.

EMH Tenets and Problems with EMHFirst, the efficient market hypothesis assumes that all investors perceive all available information in precisely the same manner. The numerous methods for analyzing and valuingstocks pose some problems for the validity of the EMH. If one investor looks for undervalued market opportunities while another investor evaluates a stock on the basis of its growth potential, these two investors will already have arrived at a different assessment of the stock’s fair market value. Therefore, one argument against the EMH points out that, since investors value stocks differently, it is impossible to ascertain what a stock should be worth under an efficient market.

Secondly, under the efficient market hypothesis, no single investor is ever able to attain greater profitability than another with the same amount of invested funds: their equal possession of information means they can only achieve identical returns. But consider the wide range of investment returns attained by the entire universe of investors, investment funds and so forth. If no investor had any clear advantage over another, would there be a range of yearly returns in the mutual fund industry from significant losses to 50% profits, or more? According to the EMH, if one investor is profitable, it means the entire universe of investors is profitable. In reality, this is not necessarily the case.

Thirdly (and closely related to the second point), under the efficient market hypothesis, no investor should ever be able to beat the market, or the average annual returns that all investors and funds are able to achieve using their best efforts. This would naturally imply, as many market experts often maintain, that the absolute best investment strategy is simply to place all of one’s investment funds into an index fund, which would increase or decrease according to the overall level of corporate profitability or losses. There are, however, many examples of investors who have consistently beat the market – you need look no further than Warren Buffett to find an example of someone who’s managed to beat the averages year after year.

Qualifying the EMH
Eugene Fama never imagined that his efficient market would be 100% efficient all the time. Of course, it’s impossible for the market to attain full efficiency all the time, as it takes time for stock prices to respond to new information released into the investment community. The efficient hypothesis, however, does not give a strict definition of how much time prices need to revert to fair value. Moreover, under an efficient market, random events are entirely acceptable but will always be ironed out as prices revert to the norm.

It is important to ask, however, whether EMH undermines itself in its allowance for random occurrences or environmental eventualities. There is no doubt that such eventualities must be considered under market efficiency but, by definition, true efficiency accounts for those factors immediately. In other words, prices should respond nearly instantaneously with the release of new information that can be expected to affect a stock’s investment characteristics. So, if the EMH allows for inefficiencies, it may have to admit that absolute market efficiency is impossible.

Increasing Market Efficiency?
Although it is relatively easy to pour cold water on the efficient market hypothesis, its relevance may actually be growing. With the rise of computerized systems to analyze stock investments, trades and corporations, investments are becoming increasingly automated on the basis of strict mathematical or fundamental analytical methods. Given the right power and speed, some computers can immediately process any and all available information, and even translate such analysis into an immediate trade execution.

Despite the increasing use of computers, however, most decision-making is still done by human beings and is therefore subject to human error. Even at an institutional level, the use of analytical machines is anything but universal. While the success of stock market investingis based mostly on the skill of individual or institutional investors, people will continually search for the surefire method of achieving greater returns than the market averages.

It’s safe to say the market is not going to achieve perfect efficiency anytime soon. For greater efficiency to occur, the following criteria must be met: (1) universal access to high-speed and advanced systems of pricing analysis, (2) a universally accepted analysis system of pricing stocks, (3) an absolute absence of human emotion in investment decision-making, (4) the willingness of all investors to accept that their returns or losses will be exactly identical to all other market participants. It is hard to imagine even one of these criteria of market efficiency ever being met.

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