Efficient market hypothesis

Definition

The efficient market hypothesis (EMH) suggests that 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, as any new information is quickly incorporated into stock prices. EMH connects closely with the concepts of global capital markets and integration, as well as international portfolio investment, by influencing how investors allocate resources across different markets and assess risk versus return.

5 Must Know Facts For Your Next Test

1. There are three forms of market efficiency: weak, semi-strong, and strong, each based on different levels of information availability.
2. The hypothesis implies that technical analysis and fundamental analysis cannot consistently lead to outperforming the market because all known information is already reflected in stock prices.
3. EMH has important implications for international portfolio investment as it suggests that diversifying investments across different countries should not guarantee higher returns than local investments.
4. Critics argue against EMH by citing market anomalies and behavioral finance theories, which suggest that investors often act irrationally.
5. The concept of EMH supports passive investment strategies, where investors favor index funds over active management due to the belief that outperforming the market consistently is unlikely.

Review Questions

• How does the efficient market hypothesis relate to the allocation of resources in global capital markets?
  • The efficient market hypothesis plays a crucial role in how resources are allocated in global capital markets by asserting that asset prices reflect all available information. This means investors make decisions based on current data without the expectation of consistently achieving returns above the market average. As a result, investors may be more likely to allocate their resources across different markets without attempting to time their investments or outperform the market through analysis, leading to greater capital integration and liquidity across borders.
• What evidence challenges the efficient market hypothesis in the context of international portfolio investment?
  • Evidence challenging the efficient market hypothesis includes observed market anomalies such as momentum effects and calendar effects, where certain strategies yield returns contrary to what EMH would predict. Behavioral finance also highlights psychological biases affecting investor decisions, leading to irrational behavior that can distort market prices. In the realm of international portfolio investment, these challenges suggest that investors may sometimes find opportunities for excess returns in specific markets or regions, contradicting the notion of complete efficiency.
• Evaluate the implications of the efficient market hypothesis on investor behavior in emerging markets compared to developed markets.
  • The implications of the efficient market hypothesis on investor behavior reveal stark contrasts between emerging and developed markets. In developed markets, where information dissemination is rapid and consistent, investors tend to adopt passive strategies aligned with EMH, assuming they cannot outperform the market. However, in emerging markets, where information may be less accessible or reliable, deviations from EMH can occur, leading some investors to seek out active management opportunities in hopes of capitalizing on inefficiencies. Consequently, this can create varied investment strategies and expectations based on perceived market efficiency levels.

Related terms

Arbitrage:

The practice of taking advantage of a price difference between two or more markets, which can lead to a temporary profit.

Market Efficiency: A condition where asset prices reflect all available information, leading to fair pricing and optimal allocation of resources.

Random Walk Theory: The theory that stock price changes are random and unpredictable, which supports the idea that markets are efficient.