Efficient market hypothesis

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Template:Tone In finance, the efficient market hypothesis (EMH) asserts that financial markets are "efficient", or that prices on traded assets, e.g. stocks, bonds, or property, already reflect all known information and therefore are accurate in the sense that they reflect the collective beliefs of all investors about future prospects. The efficient market hypothesis implies that it is not possible to consistently outperform the market — appropriately adjusted for risk — by using any information that the market already knows, except through luck or obtaining and trading on inside information. It further suggests that the future flow of news (that which will determine future stock prices) is random and unknowable in the present. The EMH is the central part of Efficient market theory (EMT).

It is a common misconception that EMH requires that investors behave rationally. This is not in fact the case. EMH allows that when faced with new information, some investors may overreact and some may underreact. All that is required by the EMH is that investors' reactions be random enough that the net effect on market prices cannot be reliably exploited to make an abnormal profit. Under EMH, the market may, in fact, behave irrationally for a long period of time. Crashes, bubbles and depressions are all consistent with efficient market hypothesis, so long as this irrational behavior is not predictable or exploitable.

There are three common forms in which the efficient market hypothesis is commonly stated — weak form efficiency, semi-strong form efficiency and strong form efficiency, each of which have different implications for how markets work.

1 Weak-form efficiency
2 Semi-strong form efficiency
3 Strong-form efficiency
4 Arguments concerning the validity of the hypothesis
5 An alternative theory: Behavioral Finance
6 See also
7 External links

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Weak-form efficiency

No excess returns can be earned by using investment strategies based on historical share prices or other financial data.
Weak-form efficiency implies that no Technical analysis techniques will be able to consistently produce excess returns.
In a weak-form efficient market current share prices are the best, unbiased, estimate of the value of the security. Theoretical in nature, weak form efficiency advocates assert that fundamental analysis can be used to identify stocks that are undervalued and overvalued. Therefore, keen investors looking for profitable companies can earn profits by researching financial statements.

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Semi-strong form efficiency

Share prices adjust instantaneously and in an unbiased fashion to publicly available new information, so that no excess returns can be earned by trading on that information.
Semi-strong-form efficiency implies that Fundamental analysis techniques will not be able to reliably produce excess returns.
To test for semi-strong-form efficiency, the adjustments to previously unknown news must be of a reasonable size and must be instantaneous. To test for this, consistent upward or downward adjustments after the initial change must be looked for. If there are any such adjustments it would suggest that investors had interpreted the information in a biased fashion and hence in an inefficient manner.

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Strong-form efficiency

Share prices reflect all information and no one can earn excess returns.
To test for strong form efficiency, a market needs to exist where investors cannot consistently earn excess returns over a long period of time. When the topic of insider trading is introduced, where an investor trades on information that is not yet publicly available, the idea of a strong-form efficient market seems impossible. Studies on the U.S. stock market have shown that people do trade on inside information. It was also found though that others monitored the activity of those with inside information and in turn followed, having the effect of reducing any profits that could be made.
Even though many fund managers have consistently beaten the market, this does not necessarily invalidate strong-form efficiency. We need to find out how many managers in fact do beat the market, how many match it, and how many underperform it. The results imply that performance relative to the market is more or less normally distributed, so that a certain percentage of managers can be expected to beat the market. Given that there are tens of thousand of fund managers worldwide, then having a few dozen star performers is perfectly consistent with statistical expectations.

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Arguments concerning the validity of the hypothesis

Some observers dispute the notion that markets behave consistently with the efficient market hypothesis, especially in its stronger forms. Some economists, mathematicians and market practitioners cannot believe that man-made markets are strong-form efficient when there are prima facie reasons for inefficiency including the slow diffusion of information, the relatively great power of some market participants (e.g. financial institutions), and the existence of apparently sophisticated professional investors. The way that markets react to news surprises is perhaps the most visible flaw in the efficient market hypothesis. For example, news events such as surprise interest rate changes from central banks are not instantaneously taken account of in stock prices, but rather cause sustained movement of prices over periods from hours to months.

Another observed discrepancy between the theory and real markets is that at market extremes irrationality is the norm: in the late stages of a bull market, the market is driven by buyers who take little notice of underlying value, towards the end of a crash, markets go into free fall as participants extricate themselves from positions regardless of the unusually good value that their positions represent. This is indicated by the large differences in the valuation of stocks compared to fundamentals (such as forward price to earnings ratios) in bull markets compared to bear markets. A theorist might say that rational (and hence, presumably, powerful) participants should always immediately take advantage of the artificially high or artificially low prices caused by the irrational participants by taking opposing positions, but this is observably not, in general, enough to prevent bubbles and crashes developing. It may be inferred that many rational participants are aware of the irrationality of the market at extremes and are willing to allow irrational participants to drive the market as far as they will, and only take advantage of the prices when they have more than merely fundamental reasons that the the market will return towards fair value. Behavioural finance explains that when entering positions market participants are not driven primarily by whether prices are cheap or expensive, but by whether they expect them to rise or fall. To ignore this can be hazardous: Alan Greenspan warned of "irrational exuberance" in the markets in 1996, but some traders who sold short ludicrously overvalued new economy stocks around this time had to accept serious losses as prices reached even more ludicrous levels. As John Maynard Keynes succintly commented "Markets can remain irrational longer than you can remain solvent". [1]

The efficient market hypothesis was introduced in the late 1960s. Prior to that, the prevailing view was that markets were inefficient. Inefficiency was commonly believed to exist e.g. in the United States and United Kingdom stock markets. However, earlier work by Kendall (1953) suggested that changes in UK stock market prices were random. Later work by Brealey and Dryden, and also by Cunningham found that there were no significant dependences in price changes suggesting that the UK stock market was weak-form efficient.

Further to this evidence that the UK stock market is weak form efficient, other studies of capital markets have pointed toward them being semi strong-form efficient. Studies by Firth (1976, 1979 and 1980) in the United Kingdom have compared the share prices existing after a takeover announcement with the bid offer. Firth found that the share prices were fully and instantaneously adjusted to their correct levels, thus concluding that the UK stock market was semi strong-form efficient.

It may be that professional and other market participants who have discovered reliable trading rules or stratagems see no reason to divulge them to academic researchers. It might be that there is an information gap between the academics who study the markets and the professionals who work in them. Some observers point to seemingly inefficient features of the markets that can be exploited e.g seasonal tendencies and divergent returns to assets with various characteristics. E.g. factor analysis and studies of returns to different types of investment strategies suggest that some types of stocks may outperform the market long-term (e.g in the UK, the USA and Japan).

There exists a small number of investors who have outperformed the market over long periods of time, in a way which it is statistically unreasonable to attribute to good luck, including Peter Lynch, Warren Buffett, and Bill Miller. These investors' strategies are to a large extent based on identifying markets where prices do not accurately reflect the available information, in direct contradiction to the efficient market hypothesis which explicitly implies that no such opportunities exist. This fact implies that the efficient market hypothesis is, at best, an approximation to reality which is significantly inaccurate. Warren Buffett has on several occasions pointed out that the EMH is not correct, on one occasion wryly saying "I'd be a bum on the street with a tin cup if the markets were always efficient" and on another saying "The professors who taught Efficient Market Theory said that someone throwing darts at the stock tables could select stock portfolio having prospects just as good as one selected by the brightest, most hard-working securities analyst. Observing correctly that the market was frequently efficient, they went on to conclude incorrectly that it was always efficient." [2]

A paper on the relationship between the Efficient Market Hypothesis (EMH) and trading, can be downloaded from www.nalin.ca

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An alternative theory: Behavioral Finance

Opponents of the EMH sometimes cite examples of market movements that seem inexplicable in terms of conventional theories of stock price determination, for example the stock market crash of October 1987 where most stock exchanges crashed at the same time. It is virtually impossible to explain the scale of those market falls by reference to any news event at the time. The explanation may lie either in the mechanics of the exchanges (e.g. no safety nets to discontinue trading initiated by program sellers) or the peculiarities of human nature.

Behavioural psychology approaches to stock market trading are among some of the more promising alternatives to EMH (and some investment strategies seek to exploit exactly such inefficiencies). A growing field of research called behavioral finance studies how cognitive or emotional biases, which are individual or collective, create anomalies in market prices and returns that may be inexplicable via EMH alone.

Theory on Talk Page

The most disturbing trend in all such discussions is the insistence on an absolutist position on whether the hypotheses are right/wrong. There must obviously be some level of efficiency in the markets. The question should be how much? Not an all-or-nothing "declaration".

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