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. Under this hypothesis, it is impossible to consistently achieve higher returns than the average market return on a risk-adjusted basis, as any new information is quickly absorbed into stock prices. This concept ties closely to insider trading and market manipulation as it suggests that any attempt to exploit market inefficiencies through these means would be futile.

5 Must Know Facts For Your Next Test

1. EMH is often categorized into three forms: weak, semi-strong, and strong, each varying in the level of information reflected in asset prices.
2. In an efficient market, technical analysis and fundamental analysis are unlikely to provide consistent advantages for investors.
3. Behavioral finance suggests that psychological factors can lead to market inefficiencies, contradicting the EMH.
4. Regulations against insider trading aim to protect market efficiency by ensuring all investors have equal access to material information.
5. Market manipulation can create temporary price changes that may seem to challenge EMH; however, such activities are illegal and often detected by regulators.

Review Questions

• How does the Efficient Market Hypothesis challenge the validity of insider trading as a profitable strategy?
  • The Efficient Market Hypothesis asserts that all available information is already reflected in stock prices, which implies that insider trading cannot provide a sustainable advantage. If markets are efficient, any non-public information would be quickly absorbed into prices, making it impossible for insiders to consistently outperform the market. Therefore, engaging in insider trading would not lead to abnormal returns as suggested by EMH.
• Discuss how market manipulation might temporarily disrupt the principles of the Efficient Market Hypothesis.
  • Market manipulation can temporarily distort asset prices away from their intrinsic values by creating false impressions of supply and demand. Such actions can lead to brief periods where prices do not reflect all available information, thus challenging the EMH. However, these manipulations are typically unsustainable and will eventually correct themselves as the true information surfaces, reinforcing the idea that markets tend toward efficiency in the long run.
• Evaluate the implications of behavioral finance on the Efficient Market Hypothesis and its relevance to real-world investing.
  • Behavioral finance introduces concepts such as cognitive biases and irrational behaviors that challenge the foundations of the Efficient Market Hypothesis. It suggests that investors do not always act rationally, leading to anomalies and inefficiencies in the market. This insight is significant because it highlights that while EMH provides a theoretical framework for understanding market dynamics, real-world investing is often influenced by human psychology and behavior, indicating that opportunities for excess returns may still exist despite EMH.

Related terms

Insider Trading: The illegal practice of trading stocks based on non-public, material information about a company.

Market Manipulation: The act of artificially inflating or deflating the price of a security for the purpose of making a profit.

Arbitrage: The simultaneous purchase and sale of an asset in different markets to profit from price discrepancies.