Efficient market hypothesis (EMH)

Definition

The efficient market hypothesis (EMH) is a financial theory that asserts that asset prices reflect all available information at any given time. This means that it is impossible to consistently achieve higher returns than average market returns on a risk-adjusted basis, since any new information that could affect a stock's value is quickly incorporated into its price. The EMH is closely tied to how equity securities are valued and the structure of the markets in which they are traded.

5 Must Know Facts For Your Next Test

1. The EMH is categorized into three forms: weak, semi-strong, and strong, each based on different levels of information reflected in stock prices.
2. In a weak form market, past prices and volume data are fully reflected in current stock prices, making technical analysis ineffective.
3. The semi-strong form asserts that all publicly available information, including earnings reports and news articles, is already factored into stock prices.
4. In strong form efficiency, even insider information is assumed to be reflected in stock prices, which challenges the legality of insider trading.
5. Real-world evidence shows mixed results for EMH, leading to debates about its validity and prompting alternative theories like behavioral finance.

Review Questions

• How does the efficient market hypothesis impact investment strategies for individual investors?
  • The efficient market hypothesis suggests that since all known information is already reflected in stock prices, individual investors cannot consistently outperform the market through stock picking or market timing. This means that passive investment strategies, such as investing in index funds, may be more effective than attempting to identify undervalued stocks or timing market movements. Understanding EMH encourages investors to focus on long-term strategies rather than trying to outsmart the market.
• Discuss the implications of the different forms of EMH on the validity of technical and fundamental analysis.
  • The different forms of EMH imply varying levels of effectiveness for technical and fundamental analysis. In weak form efficiency, technical analysis is deemed ineffective since past price movements do not provide an advantage in predicting future prices. In semi-strong form efficiency, fundamental analysis also loses its edge because all publicly available information is already accounted for in stock prices. This leads to the conclusion that if markets are truly efficient, neither technical nor fundamental analysis would yield consistent excess returns.
• Evaluate the criticisms of the efficient market hypothesis and their relevance to real-world market behavior.
  • Critics of the efficient market hypothesis argue that real-world markets often exhibit inefficiencies due to irrational behavior among investors, as described by behavioral finance. Factors like herd behavior, overconfidence, and emotional biases can lead to mispricing of assets and create opportunities for skilled investors. These criticisms highlight that while EMH provides a foundational understanding of how markets operate, actual investor behavior can deviate significantly from the assumptions of rationality inherent in the hypothesis. This opens up discussions about whether markets can be considered truly efficient or if there are persistent anomalies that can be exploited.

Related terms

Market Efficiency:

Market efficiency refers to the degree to which stock prices reflect all available information, with fully efficient markets responding instantaneously to new data.

Random Walk Theory:

The random walk theory suggests that stock price changes are independent of each other and follow a random path, supporting the notion that predicting stock movements is futile.

Behavioral Finance:

Behavioral finance explores how psychological factors and biases influence investors' decisions and market outcomes, contrasting with the assumptions of rational behavior in EMH.