Efficient Market Hypothesis

Definition

The efficient market hypothesis (EMH) is an investment theory that states that asset prices fully reflect all available information, making it impossible for investors to consistently outperform the overall market through active stock selection or market timing. This hypothesis suggests that the financial markets are highly efficient in processing information, and that stock prices adjust rapidly to new information, making it difficult for investors to generate above-average returns.

5 Must Know Facts For Your Next Test

1. The efficient market hypothesis suggests that it is impossible to 'beat the market' because all relevant information is already reflected in stock prices.
2. The EMH is based on the assumption that investors are rational and quickly incorporate new information into asset prices, making the market highly efficient.
3. There are three forms of market efficiency: weak, semi-strong, and strong, which differ in the amount of information reflected in asset prices.
4. Proponents of the EMH argue that active investment strategies, such as stock picking and market timing, are futile because they cannot consistently outperform the market.
5. Critics of the EMH argue that markets are not always efficient, and that investors can take advantage of mispricing and other anomalies to generate above-average returns.

Review Questions

• Explain how the efficient market hypothesis relates to the concept of interacting with investors, intermediaries, and other market participants.
  • The efficient market hypothesis suggests that asset prices reflect all available information, which means that investors, intermediaries, and other market participants cannot consistently outperform the market by actively trading or seeking out mispriced assets. This implies that investors should focus on passive investment strategies, such as index funds, rather than trying to 'beat the market' through active stock selection or market timing. The efficient market hypothesis also suggests that the role of intermediaries, such as financial advisors and brokers, may be limited, as they cannot consistently provide investment advice that leads to above-average returns.
• Describe how the efficient market hypothesis relates to the concept of efficient markets and the historical picture of returns to stocks.
  • The efficient market hypothesis is closely tied to the concept of efficient markets, as it suggests that asset prices fully reflect all available information, making it impossible for investors to consistently earn above-average returns. This implies that the historical picture of returns to stocks should show that active investment strategies, such as stock picking and market timing, cannot outperform the market over the long run. The random walk theory, which is related to the efficient market hypothesis, suggests that stock prices follow a random pattern, making it impossible to predict future price movements based on past performance. This further supports the idea that the historical picture of returns to stocks should show that it is difficult, if not impossible, for investors to consistently beat the market.
• Analyze how the efficient market hypothesis challenges the notion of active investment strategies and the ability of investors to generate above-average returns.
  • The efficient market hypothesis directly challenges the viability of active investment strategies, such as stock picking and market timing, by suggesting that it is impossible for investors to consistently outperform the market. This is because the EMH posits that asset prices already reflect all available information, making it impossible for investors to identify undervalued or overvalued assets. The EMH also implies that the historical picture of returns to stocks should show that active investment strategies cannot generate above-average returns over the long run, as the market is highly efficient in processing information and adjusting prices accordingly. This challenges the notion that investors can generate consistent alpha through their investment acumen and calls into question the value of active investment management, which is a fundamental tenet of modern finance.

Related terms

Market Efficiency: The degree to which asset prices reflect all available information, making it impossible for investors to consistently earn above-average returns.

Random Walk Theory: The theory that stock prices follow a random pattern, making it impossible to predict future price movements based on past performance.

Information Asymmetry: The situation where one party has more or better information than another party, which can lead to an imbalance of power in transactions.