Efficient market hypothesis

Definition

The efficient market hypothesis (EMH) posits that financial markets are 'informationally efficient', meaning that asset prices reflect all available information at any given time. This implies that it is impossible to consistently achieve higher returns than the average market return on a risk-adjusted basis, because stock prices already incorporate and reflect all relevant data.

5 Must Know Facts For Your Next Test

1. The efficient market hypothesis is often categorized into three forms: weak, semi-strong, and strong, each varying by the type of information reflected in asset prices.
2. Weak form EMH states that all past market prices are reflected in stock prices, meaning technical analysis cannot provide an advantage.
3. Semi-strong form EMH asserts that all publicly available information is already accounted for in stock prices, making fundamental analysis ineffective.
4. Strong form EMH claims that all information, both public and private, is reflected in stock prices, meaning insider trading cannot lead to excess returns.
5. The Chicago School economists strongly support the EMH, arguing for minimal government intervention in markets as they believe markets are capable of self-regulation.

Review Questions

• How does the efficient market hypothesis challenge traditional views on stock trading and investment strategies?
  • The efficient market hypothesis challenges traditional views by suggesting that consistent outperformance through stock trading strategies is nearly impossible since all available information is already reflected in stock prices. As a result, investors cannot reliably exploit market inefficiencies for profit. This leads to the conclusion that passive investment strategies, such as index funds, may be more effective than active trading strategies focused on picking individual stocks.
• Evaluate the implications of the efficient market hypothesis for policymakers and regulatory bodies regarding market intervention.
  • The implications of the efficient market hypothesis for policymakers are significant, as it suggests that markets operate efficiently without the need for substantial intervention. If markets accurately reflect all available information, then attempts by regulatory bodies to correct perceived inefficiencies may be unnecessary or even counterproductive. This perspective encourages a hands-off approach, promoting policies that enhance transparency and information dissemination rather than direct market manipulation.
• Critically assess the limitations of the efficient market hypothesis in light of behavioral finance and observed market anomalies.
  • While the efficient market hypothesis provides a foundational understanding of how financial markets operate, its limitations become apparent when considering insights from behavioral finance and documented market anomalies. Behavioral finance highlights how psychological factors and irrational behaviors can lead to mispricing and inefficiencies that contradict EMH. Observations such as bubbles and crashes illustrate that markets can deviate from rational expectations due to human emotions. Consequently, while EMH offers valuable insights into market efficiency, it fails to fully account for real-world complexities influencing investor behavior and market dynamics.

Related terms

Random Walk Theory: A theory suggesting that stock price movements are random and unpredictable, supporting the idea that past price movements cannot be used to predict future prices.

Market Anomalies: Patterns in stock prices or returns that seem to contradict the predictions of the efficient market hypothesis, indicating potential inefficiencies in the market.

Behavioral Finance: A field of study that examines how psychological influences and cognitive biases affect the financial behaviors of investors and the functioning of markets.