Efficient Market Hypothesis

Definition

The Efficient Market Hypothesis (EMH) is a theory that suggests 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 average market returns on a risk-adjusted basis because stock prices already incorporate and reflect all relevant information. As a result, investors cannot outperform the market through expert stock selection or market timing, which has implications for various areas, including foreign exchange, global equity markets, and international diversification strategies.

5 Must Know Facts For Your Next Test

1. There are three forms of market efficiency: weak, semi-strong, and strong, each reflecting different levels of information being incorporated into asset prices.
2. In a weak-form efficient market, past prices and trading volumes do not predict future prices, while in a semi-strong form, all publicly available information is reflected in stock prices.
3. The strong-form of efficiency suggests that even insider information is already included in stock prices, making it impossible for anyone to have an advantage.
4. If markets are truly efficient, then active portfolio management and technical analysis are unlikely to yield consistent excess returns over passive management strategies.
5. Behavioral finance challenges the EMH by highlighting how investor psychology and emotions can lead to irrational market behaviors that deviate from efficiency.

Review Questions

• How does the Efficient Market Hypothesis impact trading strategies in financial markets?
  • The Efficient Market Hypothesis fundamentally alters how traders approach financial markets. If markets are efficient, it suggests that attempting to outperform the market through active trading or stock picking is futile because all available information is already priced into assets. Consequently, many investors shift towards passive investment strategies, accepting market returns rather than trying to beat them. This understanding encourages a focus on long-term investment horizons rather than short-term speculative trading.
• Discuss the implications of the Efficient Market Hypothesis for global equity markets and their interconnectedness.
  • The Efficient Market Hypothesis implies that global equity markets should quickly integrate information from around the world, reflecting it in asset prices almost instantaneously. This interconnectedness means that news affecting one market can influence others immediately, leading to synchronous price adjustments across borders. Investors participating in multiple markets must consider how events in one country might affect stock prices elsewhere due to this rapid flow of information and the overall efficiency of global financial systems.
• Evaluate the role of the Efficient Market Hypothesis in assessing the benefits and challenges of international diversification for investors.
  • Evaluating international diversification through the lens of the Efficient Market Hypothesis reveals both benefits and challenges for investors. On one hand, if markets are efficient globally, diversification can reduce risk without sacrificing returns since asset prices reflect available information across borders. However, investors face challenges as differing levels of market efficiency can lead to discrepancies in pricing and risk assessment. Moreover, behavioral biases may cause inefficiencies in certain markets, potentially allowing savvy investors to exploit opportunities that contradict EMH principles. Understanding these dynamics is essential for making informed investment decisions.

Related terms

Market Efficiency: The degree to which stock prices reflect all available information, with high efficiency meaning prices quickly adjust to new information.

Random Walk Theory: A financial theory suggesting that stock price movements are random and unpredictable, supporting the idea that past price movements do not influence future movements.

Arbitrage: The practice of taking advantage of a price difference between two or more markets, which in an efficient market should be quickly eliminated.