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 the price. In other words, technical analysis of prices is of no use.
- Semistrong EMH. This states 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 the Efficient Market Hypothesis
- Markets are efficient in determining the 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 an efficient market hypothesis it suggests 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 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.
Criticisms of the efficient market hypothesis
Stock Prices often reflect evidence of:
- Irrational exuberance – people getting carried away by booms and asset bubbles (e.g. US house prices in the 2000s, Dot Com Bubble and Bust.
- Behavioural economics places greater emphasis on the irrationality of human behaviour in making economic decisions e.g. herding effect e.t.c
Empirical evidence that stock prices do not reflect. E.g. According to Dreman, in a 1995 paper, low P/E stocks have greater returns.
Even the founder of EMH, Eugene Fama found in a 1990s study that many stocks didn’t follow a random walk model but that ‘value’ stocks outperformed. They also found a ‘momentum effect’ where stocks which had done well in the past, often continued to do well in the future. Fama tried to defend his theory by saying cheap stocks had a greater risk.
Joseph Stiglitz published a proof saying that if the efficient market hypothesis was true it would be logically irrational to spend money on research – which people clearly do.
An Economic Model turned to myth – The Myth of the Rational Market by Justin Fox