Efficient Market Hypothesis

Definition

The Efficient Market Hypothesis (EMH) is a theory that asserts that financial markets are 'informationally efficient,' meaning that asset prices reflect all available information at any given time. This concept implies that it is impossible to consistently achieve higher returns than the average market return on a risk-adjusted basis, as all known information is already accounted for in asset prices. In the context of valuation, understanding EMH helps analysts determine how comparable companies are priced relative to the information they have, impacting investment decisions and market predictions.

5 Must Know Facts For Your Next Test

1. EMH is categorized into three forms: weak, semi-strong, and strong, each based on the types of information reflected in stock prices.
2. In a weak-form efficient market, current stock prices reflect all past trading information, making technical analysis ineffective.
3. A semi-strong efficient market incorporates all publicly available information, suggesting that fundamental analysis cannot yield consistent excess returns.
4. In a strong-form efficient market, all information—public and private—is reflected in stock prices, implying that even insider trading cannot consistently generate profits.
5. Critics argue that behavioral finance examples demonstrate systematic mispricing in markets, challenging the validity of EMH.

Review Questions

• How does the Efficient Market Hypothesis impact the valuation techniques used in comparable company analysis?
  • The Efficient Market Hypothesis suggests that stock prices reflect all available information. Therefore, when conducting comparable company analysis, analysts must consider whether the multiples they use are based on efficient market pricing. If markets are truly efficient, then the valuations derived from comparable companies will already account for all relevant information, making it difficult to justify deviations from those valuations without new insights.
• What are the implications of weak-form efficiency on technical analysis and its relevance in investment decisions?
  • In a weak-form efficient market, past price movements and trading volume do not provide an edge for investors using technical analysis to predict future price movements. This means that relying on chart patterns or historical trends would not yield consistent excess returns. As such, investors should focus more on fundamental analysis or consider alternative strategies since technical indicators would be less effective in an efficient market context.
• Evaluate the criticisms of the Efficient Market Hypothesis in relation to real-world market behaviors and investor psychology.
  • Critics of the Efficient Market Hypothesis argue that real-world market behaviors often reflect irrationality and psychological biases that lead to systematic mispricing. Behavioral finance studies show that investors do not always act rationally; they may overreact or underreact to news based on emotions rather than facts. These behaviors challenge EMH's assumption of rational actors and suggest that markets can be inefficient over short-term periods. Understanding these inefficiencies is crucial for investors who aim to exploit mispriced securities or identify trends that deviate from the expected outcomes proposed by EMH.

Related terms

Market Efficiency: Market efficiency refers to how quickly and accurately stock prices reflect new information, which is a key component of the Efficient Market Hypothesis.

Arbitrage: Arbitrage involves taking advantage of price differences in different markets; under EMH, arbitrage opportunities should be rare or quickly eliminated.

Behavioral Finance: Behavioral finance studies how psychological factors influence investor behavior, often contradicting the assumptions of the Efficient Market Hypothesis.