Efficient market hypothesis (EMH)

Definition

The efficient market hypothesis (EMH) is a financial theory that suggests that asset prices fully reflect all available information at any given time. This means that it’s impossible to consistently achieve higher returns than the overall market, as any new information is quickly incorporated into stock prices. EMH has important implications for investors, suggesting that active trading strategies are unlikely to outperform passive investing.

5 Must Know Facts For Your Next Test

1. EMH is categorized into three forms: weak, semi-strong, and strong, depending on the type of information reflected in stock prices.
2. The weak form suggests that past stock prices cannot predict future prices, while the semi-strong form states that all publicly available information is reflected in prices.
3. Strong form EMH asserts that even insider information is already reflected in stock prices, making it impossible for anyone to gain an advantage.
4. Critics argue that anomalies like bubbles and crashes challenge EMH, suggesting markets may not always behave efficiently.
5. Behavioral finance provides an alternative perspective, emphasizing psychological factors that can lead to irrational investor behavior and market inefficiencies.

Review Questions

• How does the efficient market hypothesis challenge the effectiveness of active trading strategies?
  • The efficient market hypothesis posits that all known information is already reflected in stock prices, making it nearly impossible for investors to consistently outperform the market through active trading strategies. If markets are efficient, then any new information is quickly absorbed, meaning that opportunities for excess returns disappear almost instantly. This challenges the rationale for actively managed funds which rely on the belief that skilled managers can identify undervalued stocks and outperform benchmarks.
• What are the implications of the different forms of EMH for investors looking to develop a portfolio strategy?
  • Understanding the different forms of EMH helps investors decide between active and passive strategies. The weak form suggests that technical analysis won’t yield consistent profits, while the semi-strong form indicates that fundamental analysis may also be ineffective since all public information is already priced in. Consequently, many investors might lean towards passive investing strategies, such as index funds, as they are less likely to incur costs associated with active trading while still capturing overall market returns.
• Critically evaluate how behavioral finance challenges the assumptions of the efficient market hypothesis and what this means for market behavior.
  • Behavioral finance introduces concepts such as cognitive biases and emotional decision-making that challenge the assumptions of the efficient market hypothesis. It argues that investors often act irrationally due to overconfidence or herd behavior, leading to market anomalies like bubbles and crashes. This perspective suggests that markets may not always be efficient, as prices can deviate from their intrinsic values based on collective psychological factors, prompting a reevaluation of investment strategies and risk management practices.

Related terms

Market Efficiency: The degree to which stock prices reflect all available, relevant information.

Random Walk Theory: The theory that stock price changes are random and unpredictable, supporting the notion that past movements do not predict future movements.

Arbitrage: The practice of taking advantage of a price difference between two or more markets, often used in attempts to exploit inefficiencies.