Efficient market hypothesis

Definition

The efficient market hypothesis (EMH) is a theory that suggests that asset prices fully reflect all available information at any given time. This means that it is impossible to consistently achieve higher returns than the average market return on a risk-adjusted basis because prices always incorporate and reflect all relevant data. EMH has profound implications for stock market speculation and financial innovations as it challenges the effectiveness of active management and the possibility of arbitrage.

5 Must Know Facts For Your Next Test

1. EMH is categorized into three forms: weak, semi-strong, and strong, each differing in the type of information considered.
2. In a weak form efficient market, past price movements cannot predict future price movements, making technical analysis ineffective.
3. The semi-strong form posits that all publicly available information is reflected in stock prices, making fundamental analysis unhelpful for excess returns.
4. Strong form efficiency states that all information, public and private, is reflected in stock prices, meaning even insider trading cannot yield consistent profits.
5. Critics of EMH argue that behavioral finance provides evidence of irrational investor behavior, leading to market bubbles and crashes contrary to EMH predictions.

Review Questions

• How does the efficient market hypothesis challenge traditional investment strategies?
  • The efficient market hypothesis suggests that since all available information is already reflected in stock prices, traditional investment strategies like stock picking or market timing are unlikely to consistently outperform the market. This challenges the notion of active management by implying that investors cannot achieve higher returns than those available through passive index investing over the long term. As a result, many investors may adopt passive investment strategies instead.
• Evaluate the implications of the efficient market hypothesis on financial innovations in stock trading.
  • The efficient market hypothesis has significant implications for financial innovations, particularly in algorithmic trading and quantitative analysis. If markets are truly efficient, then these innovations may primarily serve to execute trades at lower costs rather than provide an edge in predicting price movements. However, if markets are not fully efficient due to behavioral biases or informational asymmetries, then these technologies could exploit inefficiencies for profit, raising questions about their overall impact on market dynamics.
• Assess the relevance of behavioral finance in critiquing the assumptions made by the efficient market hypothesis.
  • Behavioral finance provides critical insights into the assumptions of the efficient market hypothesis by highlighting how psychological factors can lead to irrational investor behavior and market anomalies. These behaviors can create mispricing of assets, suggesting that markets are not always efficient as EMH claims. The existence of phenomena like bubbles and crashes challenges the idea that markets always reflect true value based on available information, indicating that human emotions and cognitive biases play a significant role in financial markets.

Related terms

Arbitrage: The practice of taking advantage of a price difference between two or more markets, buying low in one and selling high in another.

Market Efficiency: A condition in which asset prices reflect all available information, leading to fair pricing of securities in the market.

Behavioral Finance: A field of study that examines the psychological factors that influence investors' decisions and how these can lead to market inefficiencies.