Efficient Market Hypothesis

Definition

The Efficient Market Hypothesis (EMH) is a theory stating that financial markets are 'informationally efficient', meaning that asset prices reflect all available information at any given time. According to EMH, it’s impossible to consistently achieve higher returns than the average market returns on a risk-adjusted basis, since market prices always incorporate and reflect all relevant data.

5 Must Know Facts For Your Next Test

1. EMH was developed in the 1960s by Eugene Fama, who proposed three forms: weak, semi-strong, and strong efficiency, each varying by the type of information considered.
2. The weak form of EMH states that past stock prices are not useful for predicting future prices, as all historical information is already reflected in current prices.
3. The semi-strong form suggests that all publicly available information, including earnings reports and news releases, is already accounted for in stock prices.
4. The strong form posits that even insider information cannot provide an advantage in the market, as all information—public and private—is already included in stock prices.
5. Critics of EMH point to numerous market anomalies, such as bubbles and crashes, as evidence that markets can be irrational and influenced by behavioral factors.

Review Questions

• How does the Efficient Market Hypothesis relate to the concept of market anomalies?
  • The Efficient Market Hypothesis posits that asset prices reflect all available information, making it difficult to outperform the market consistently. However, market anomalies represent instances where asset prices deviate from what would be expected under EMH. These anomalies suggest that there are inefficiencies in the market, often due to behavioral biases or overreactions by investors, indicating that not all available information is accurately reflected in stock prices.
• Discuss how behavioral finance challenges the assumptions of the Efficient Market Hypothesis.
  • Behavioral finance introduces psychological factors into financial decision-making, highlighting how emotions and cognitive biases can lead investors to make irrational choices. This challenges the Efficient Market Hypothesis by suggesting that if investors are not always rational or informed, then asset prices may not accurately reflect all available information. Examples such as overconfidence and herd behavior can lead to mispricing of assets, creating situations where consistent outperformance of the market might be possible.
• Evaluate the implications of the Efficient Market Hypothesis for investors seeking to develop successful trading strategies.
  • If the Efficient Market Hypothesis holds true, then it implies that investors cannot consistently achieve superior returns through active trading or stock picking, as all relevant information is already embedded in current asset prices. This leads many investors to favor passive investment strategies, such as index funds, which aim to replicate market performance rather than attempt to beat it. However, acknowledging potential market anomalies and behavioral biases may provide some investors with opportunities to exploit inefficiencies, suggesting a nuanced approach between passive and active investment strategies.

Related terms

Market Anomalies: Patterns or trends in stock prices that contradict the predictions made by the efficient market hypothesis, suggesting that not all information is reflected in asset prices.

Behavioral Finance: A field of study that combines psychology and finance to understand how cognitive biases and emotional factors influence investor behavior and market outcomes.

Random Walk Theory: The idea that stock price changes are random and unpredictable, supporting the notion that it is impossible to outperform the market consistently.