Efficient Market Hypothesis – Definition

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Efficient Market Hypothesis Definition

The efficient market hypothesis (EMH) is a financial market theory which states that the market price of a financial asset reflect all the available information.

An efficient market shows all the market information available at a period of time to investors or other market participants. The Efficient Market Hypothesis (EMH) is an investment of financial theory that created in the 1970s by Eugene Fama. It posits that all market information are reflected by the price of assets. It also maintains that stocks are priced according to their innate properties which are known to market participants. The Efficient Market Hypothesis (EMH) just like any other financial theory presents ideas that give explanations to investment in the modern world and how the market works at large. However, EMH fails to give explanations to stock market’s behavior and this is regarded as a downside.

A Little More on What is the Efficient Market Hypothesis

The efficient market hypothesis (EMH) assumes that all the available past information is already incorporated into a stock’s price. This means that an investor cannot earn risk-adjusted returns or alpha with technical or fundamental analysis. A such, it is the only inside information that makes it possible to achieve returns in excess of market expectations. If investors want to earn higher rates of return, they can only do so by investing in riskier financial assets. Someone ascribing to the EMH would say that passively investing in securities (rather than active trading) is the best market strategy.
The EMH is a highly-debated concept. The proponents of efficient market hypothesis cite the results of investors, such as Warren Buffett, who have consistently outperform the market. Opponents of the concept focus on market dips, such as the crash of 1987, to argue that prices can significantly deviate from their fair market values.

A general perception of the efficient market hypothesis is that all market participants perceive market information in an exact manner, which is not true. Due to the fact that different investors participate in the stock market with different purposes or intentions, they perceive and interpret market information differently.

Another problem with EMH is the assumption that investors perceive information in equal manner means that they will all have equal returns. That is, an investor cannot realize higher profit that another investor if they both have the same amount for investment.

The third problem with EMH is that an investor cannot earn an investment return that exceeds the performance of the market or the average annual returns of other investors. Hence, the overall level of corporate profitability or losses in the stock market affect individual investors.

Stock react to new prices or new investment information released in the market steadily, it requires some time for it to respond. Since it is impossible for a market to be efficient at all times, the Efficient Market Hypothesis (EMH) is also not efficient at all times. For instance, its failure to provide information on how much time prices need to revert to an impartial value.

Also, whether EMH makes provision for random events and future eventualities that might not be predictable is an area of concern. Since there are certain inefficiencies of the EMH theory, perfect market efficiency might be impossible.

Despite that there are certain problems attributed to the efficient market hypothesis, the theory is still relevant to the growth of the market. The computerized systems used in the analysis of stock investments have called for mathematical methods in the analysis. The use of analytical machines and mathematical methods is not universal. However, regardless of the high involvement of computers in the analysis of stock investments, the role of investors (real humans) in the decision making in stock market cannot be sidelined. Since humans participate in the decision making process, errors are inevitable. Despite humne errors that occur in decision-making, the success of stock market investment is largely based on the skill of investors.

When used in investment or trading, technical analysis involves the use of price trends and previous trading patterns in identifying trading opportunities and predicting future occurrences.  Unlike technical analysis that relies on the data of past prices or past results, EMH maintains that past results are not useful in outweighing the market. Because of this, EMH disregards technical analysis as a means to generate investment returns.

 

EMH does not only negates technical analysis but also fundamental analysis. EMH maintains that all the market information  such as security price, abnormal return on stock cannot be made available to market participants at any given time using the fundamental analysis method.

The Efficient Market Hypothesis (EMH) is a theory that holds that market can be tagged efficient if all information such as security prices and returns are fully reflected and made available to market participants. Portfolio management reflects how an individual investor diversifies and manages his securities as well as the constraints entailed. Usually, the goal of portfolio management is to outperform other investors in the market through unique ideas and this goal is not permissible or achievable under EMH. This is because, EMH does not allow an investor to outperform other investors or earn above the average returns. Hence, with regard to EMH, portfolio management should only focus on achieving average returns and not otherwise.

In line with the Efficient Market Hypothesis (EMH), investors are expected to make returns equal to market return and not above. In order to enable investors achieve market rate of return in an effective way, investors are encouraged to invest in index funds.

Basically, an index fund is designed to follow market rules so that the end goal of the market can be achieved. An index fund can also be an exchange-traded fund in which the performance of the fund is closely monitored in a way that it reflects the benchmark index. For investors to achieve market rate of returns, costs to invest must be minimized, diversification in a numerous amounts of stocks is also required, which is why they invest in index funds.

It is quite impossible for the market to be efficient at all times. That means full efficiency of the market is unattainable. Nevertheless, for a greater market efficiency to be achieved, there are certain criteria that must be met, these are;

  • Investors must align with the rule that returns or losses on their investment will be exact as the average market return or return of other participants.
  • An acceptable and universal analysis system of pricing stocks should be adopted.
  • The decision-making process of the market should be empty of human emotions that can lead to avoidable errors.
  • Access to advanced systems or methods of pricing analysis.

References for Efficient Market Hypothesis

Academic Research on Efficient Market Hypothesis

Investment performance of common stocks in relation to their price‐earnings ratios: A test of the efficient market hypothesis, Basu, S. (1977). The journal of Finance32(3), 663-682. Over the past two decades, behavioral finance has received a major driving force. The authors use this article as a medium to discuss the gradual shift from the traditional Efficient Market Hypothesis (EMH) to the more experimental branch of finance, termed behavioral finance. They conduct 3 different experiments to verify the Prospect theory, a famous theory created by Kahneman and Tversky.

The efficient market hypothesis and its critics, Malkiel, B. G. (2003). Journal of economic perspectives17(1), 59-82. This article explores the attacks of economists and econometricians on the efficiency of the market hypothesis and the relationship that exist between predictability and efficiency. The economists believe in the psychological and behavioral elements of stock-price determination while the econometricians argue that stock returns are to a large extent predictable. The author concludes that stock markets are far more efficient and less predictable that recent journals and article would have people believe.

Reflections on the efficient market hypothesis: 30 years later, Malkiel, B. G. (2005). Financial Review40(1), 1-9. In the past few years, financial economists have increasingly challenged the efficient market hypothesis. This article demonstrates that both in the U.S and abroad, financial managers do not exceed their index performance benchmarks. The article also provides evidence that small and large market prices do show all the available information.

Efficient market hypothesis and forecasting, Timmermann, A., & Granger, C. W. (2004). International Journal of forecasting20(1), 15-27. Market efficiency tests depend on the establishment of lucrative trading opportunities in real time, leading to a lot of important differences in the results obtained from forecasting tests. Forecasters are always researching for more predictable patterns and affect prices when they try to earn from trading opportunities. Hence, firm prediction patterns do not last for long periods of time and explode when discovered by a lot of investors.

Efficient market hypothesis, Malkiel, B. G. (1989). In Finance (pp. 127-134). Palgrave Macmillan, London. Unofficially, a financial market is efficient if it correctly shows all the information necessary to determine security prices. Officially, a financial market is only efficient according to set information, ϕ, if the security prices remain unaffected after revealing information about the prices to all participants. Information set, ϕ, also implies that it’s not possible to make profits when trading based on ϕ.

The efficient market hypothesis and insider trading on the stock market, Laffont, J. J., & Maskin, E. S. (1990). Journal of Political Economy98(1), 70-93. The authors study the behavior of a large-scale trader and form an argument that if the chances of profit are not so great, the trader will typically ensure that the market price doesn’t reveal his information, leading to a pooling equilibrium. Such equilibria have the advantage of preventing the incentive restrictions that occur in separating equilibrium.

On the emergent properties of artificial stock markets: the efficient market hypothesis and the rational expectations hypothesis, Chen, S. H., & Yeh, C. H. (2002). Journal of Economic Behavior & Organization49(2), 217-239. After studying two popular hypotheses in economics, the authors use the article as a medium to demonstrate how emergent properties can be reflected in an artificial agent-based stock market. The hypotheses studied are the rational expectations hypothesis and efficient market hypothesis. The results of their study and their observations and comments are fully discussed in this article.

Efficient market hypothesis in European stock markets, Borges, M. R. (2010). The European Journal of Finance16(7), 711-726. The data reported in this study were obtained when market efficiency was applied to stock market indexes of France, UK, Germany, Greece, Spain, and Portugal from January 1993 to December 2007. The authors report a runs test and joint variance ratio tests on the data which were performed daily and weekly from 1993-2007. After it all, they discover mixed evidence on the efficient market hypothesis.

History of the efficient market hypothesis, Sewell, M. (2011). RN11(04), 04. A financial market is only efficient, according to an information set, if the security price “fully show” the information set which simply means that they remain unaffected after revealing information about the prices to all market participants. All financial markets are efficient according to the efficient market hypothesis (EMH). EMH is most likely false as the word “fully” implies that a condition has to be fulfilled to be efficient.

The global financial crisis and the efficient market hypothesis: What have we learned?, Ball, R. (2009). Journal of Applied Corporate Finance21(4), 8-16. This article explores the limits of efficient market hypothesis and shows the misinterpretation and logical misunderstanding of the theory involved in popular arguments. These arguments play a significant role in (1) miscalculation of risks by investment practitioners, (2) creation of real estate and stock market bubbles, and (3) failure to identify the bubbles and prevent the crisis by regulators.

Efficient market hypothesis (EMH): past, present and future, Yen, G., & Lee, C. F. (2008). Review of Pacific Basin Financial Markets and Policies11(02), 305-329. After clearly describing the history of the Efficient Market Hypothesis (EMH), the authors, in a methodological fashion, outline the experimental findings from 1960 to 1990 that have an effect on EMH. The heading of the findings includes “supporting empirical findings as documented in the 1960s”, “mixed empirical findings as merged in the late 1970s through 1980s” and “challenging empirical findings as appeared in 1990s”. The authors then illustrate the continuous 21st-century debate based on the experimental proof at hand and provide an overall analysis of the EMH.

Stock prices and the efficient market hypothesis: Evidence from a panel stationary test with structural breaks, Lee, C. C., Lee, J. D., & Lee, C. C. (2010). Japan and the world economy22(1), 49-58. The ability of the efficient market hypothesis to stand strong in stock markets at different economic development levels was investigated in this paper. The period of investigation was between January 1999 and May 2007. The authors employ a state-of-the-art panel data test that integrates multiple structural breaks.

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