Efficient market hypothesis (EMH)

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 connects with the idea of portfolio performance measures, as the hypothesis suggests that it is impossible to consistently achieve higher returns than average market returns on a risk-adjusted basis, thus influencing how investors evaluate and manage their portfolios.

5 Must Know Facts For Your Next Test

1. EMH is categorized into three forms: weak, semi-strong, and strong, based on the types of information reflected in asset prices.
2. Weak form EMH states that current stock prices reflect all past trading information, while semi-strong form EMH asserts that prices reflect all publicly available information.
3. Strong form EMH claims that asset prices reflect all information, public and private, meaning even insider information cannot lead to consistent excess returns.
4. According to EMH, active management strategies are unlikely to outperform passive strategies due to the efficiency of the market.
5. Critics of EMH argue that market anomalies and investor behavior can lead to mispricing of assets, challenging the notion that markets are perfectly efficient.

Review Questions

• How does the efficient market hypothesis impact investment strategies related to portfolio management?
  • The efficient market hypothesis suggests that since all available information is reflected in asset prices, investors cannot consistently achieve higher returns than the market. This leads to a preference for passive investment strategies, such as index funds, over active management. Portfolio managers may focus on minimizing costs and managing risk rather than attempting to outperform the market through stock picking or timing strategies.
• Evaluate the implications of weak form EMH versus semi-strong form EMH for investors using technical analysis.
  • Weak form EMH indicates that all past trading information is reflected in current stock prices, implying that technical analysis based on historical price data would not yield consistent excess returns. In contrast, semi-strong form EMH posits that all publicly available information is also incorporated into prices, further undermining technical analysis. Investors relying on these methods might find it difficult to achieve superior performance, as both forms suggest that past data and public news do not provide an edge in predicting future price movements.
• Critically analyze how the existence of market anomalies challenges the efficient market hypothesis and what this means for investment practices.
  • The presence of market anomalies, such as overreactions or underreactions to news, contradicts the efficient market hypothesis by demonstrating instances where asset prices do not fully reflect available information. These anomalies suggest that markets can be inefficient and provide opportunities for investors to exploit mispricing for profit. This critique has led some investors to adopt behavioral finance principles and alternative strategies aimed at capitalizing on psychological biases and inefficiencies in the market.

Related terms

Market Efficiency: A condition in which asset prices fully reflect all available information, leading to fair pricing and the inability to consistently outperform the market.

Random Walk Theory: The theory suggesting that stock price movements are largely unpredictable and follow a random path, supporting the notion that future price movements cannot be reliably forecasted based on past trends.

Alpha: A measure of an investment's performance on a risk-adjusted basis, indicating the excess return relative to the benchmark or expected return, often used to evaluate portfolio performance.