Efficient Market Hypothesis

June 10th, 2009 | economics -

Definition of Efficient Market Hypothesis It is the idea that the price of stocks and financial securities reflects all available information about them. If new information about a company becomes available, the price will quickly change to reflect this.

Three Types of Efficient market hypothesis

Weak EMH. This states all past market prices and data are fully reflected in the price of securities and stocks. However, some information about events shaping the company may not be fully reflected in price. In other words, technical analysis of prices is of no use.
Semistrong EMH. This states form asserts that all publicly available information is fully reflected in securities prices. In other words, fundamental analysis is of no use.
Strong Form of EMH asserts that all information is fully reflected in securities prices. In other words, even insider information is of no use.

The Efficient Market hypothesis requires certain assumptions.

Many Buyers and sellers
Agents have rational expectations and on average make good decisions about buying shares / stocks
Perfect information about market trends and profit of firms.

Implications of Efficient market Hypothesis

Markets are efficient in determining prices of financial securities.
Investors tend to be rational.
It is not possible (except through luck) to outperform the market.
Prices may not determine future stock performance e.g. the market may not know about an event which will lead to lower profit.
It is easy to buy and sell. For example, housing markets are less close to the model of efficient market hypothesis because there are significant time lags in buying selling and stamp duty e.t.c.

If we assume efficient market hypothesis it suggest regulators need to do little, if anything to prevent asset / stock market bubbles. Because according to this theory, irrational asset price bubbles shouldn’t occur. However, if the efficient market hypothesis is not true, then there is a greater a role for regulators to intervene in asset / stock bubbles to prevent a boom and bust. (assuming regulators don’t get caught up in the same irrational exuberance as investors)

If some investors ignore data and get caught up in bubbles, then in theory ‘efficient investors’ should be able to profit by ’shorting’ a boom. (see: short selling explained) But as Keynes said, the market can remain irrational for longer than you can remain solvent. In other words a bubble may last for a long time and your short positions may fail before you finally benefit from the collapse in prices.