What is Efficient Market Hypothesis (EMH)?
The efficient-market hypothesis (EMH) is a theory in financial economics that states that asset prices fully reflect all available information. A direct implication is that it is impossible to “beat the market” consistently on a risk-adjusted basis since market prices should only react to new information.
The efficient-market hypothesis was developed by Eugene Fama who argued that stocks always trade at their fair value, making it impossible for investors to either purchase undervalued stocks or sell stocks for inflated prices. As such, it should be impossible to outperform the overall market through expert stock selection or market timing, and that the only way an investor can possibly obtain higher returns is by chance or by purchasing riskier investments.
Table of Content
There are three variants of the hypothesis: “weak”, “semi-strong”, and “strong” form. The weak form of the EMH claims that trading information (levels and changes of prices and volumes) of traded assets (e.g., stocks, bonds, or property) are already incorporated in prices. If weak form efficiency holds then technical analysis cannot be used to generate superior returns. The semi-strong form of the EMH claims both that prices incorporate all publicly available information (which also includes information present in financial statements, other SEC filings etc.).
If semi-strong form efficiency holds then neither technical analysis nor fundamental analysis can be used to generate superior returns. The strong form of the EMH additionally claims that prices incorporate all public and non-public (insider) information, and therefore even insiders cannot expect to earn superior returns (compared to the uninformed public) when they trade assets of which they have inside information.
For most financial economists, however, the efficient markets hypothesis is a central idea of modern finance that has profound implications.
Random Walk and Search for Theory
In 1950s, pioneering work done by distinguished statisticians and physicists, such as Maurice Kendall, Harry Roberts, Osborne and others, found that stock prices behaved like a random walk.
A random walk means that successive stock prices are independent and identically distributed. Therefore, strictly speaking, the stock price behaviour should be characterised as a submartingale, implying that the expected change in price can be positive because investors expect to be compensated for time and risk.
Further, the expected return may change over time in response to change in risk. In short, random walk theory proclaims that stocks take a random and unpredictable path that makes all methods of predicting stock prices futile in the long run.
Search for Theory: When the empirical evidence in favour of the random walk hypothesis seemed overwhelming, the academic researchers asked the question: What is the economic process that produces a random walk? They concluded that the randomness of stock prices was the result of an efficient market. Broadly, the key links in the argument are as follows:
- Information is freely and instantaneously available to all the market participants.
- Keen competition among market participants more or less ensures that market prices will reflect intrinsic values. This means that they will fully impound all available information.
- Prices change only in response to new information that, by definition, is unrelated to previous information (otherwise it will not be new information).
- Since new information cannot be predicted in advance, price changes too cannot be forecast. Hence, prices behave like a random walk.
Efficient Market
Fama defined Efficient Market as, “A market where there are large numbers of rational profit maximisers actively competing, with each trying to predict future market values of individual securities, and where important current information is almost freely available to all participants”.
In other words, an efficient market is one in which the market price of a security is an unbiased estimate of its intrinsic value. Note that market efficiency does not imply that the market price equals intrinsic value at every point in time.
All that it says is that the errors in the market prices are unbiased. This means that the price can deviate from the intrinsic value but the deviations are random and uncorrelated with any observable variable. If the deviations of market price from intrinsic value are random, it is not possible to consistently identify over or under-valued securities.
The EMH is so called as it was assumed that the capital market is efficient in processing information. This hypothesis is based on the idea that security prices are rationally determined. Changes occur in the stock price as a result of a change in the company, industry or economy. The information about these changes would alter the stock price immediately and there would be a shift to a new level.
This movement can be either upward or downward, and is dependent on the type of information. It is argued that the shift in speculative stock prices always incorporates the best information and knowledge about fundamental values and the prices change only because of good and sensible information. Any further change in price of the stock will be based on other new pieces of information which was hitherto not available. Thus, any change in the price of a stock, which constantly seeks equilibrium, is totally independent of earlier or future changes. Further, the current price fully reflects all available information about the stock.
The hypothesis says that the market for a stock is efficient if its price is always equal to its intrinsic value. The intrinsic value of a stock is the present value of cash flows that the stock can reasonably be expected to generate (for example dividends).
The EMH is also concerned with the speed with which information is incorporated into the security prices. It is also believed that the past price sequence has information about the future price movements too. Thus, by studying the pattern of price movements and trading accordingly, it is possible to earn appropriate returns.
However, it may take several days or weeks before the impact of any new information can be assessed. This can lead to the price being volatile for a number of days before it adjusts to a new level. This also provides an opportunity to earn further returns. The instance of the S& P 500 stock index beating the overall market by about 60 per cent to 80 per cent of the time has been quoted by proponents of EMH to substantiate the efficiency of the hypothesis.
Assumptions of Efficient Market Hypothesis (EMH)
Three basic theoretical arguments form the basis of EMH. They are as follows:
- Investors are rational and hence securities are valued rationally.
- Careful account of all available information is taken by everyone before making investment decisions. Each decision is related to internal consistency and has to be made in a systematic way so that it is in agreement with one another.
- The decision maker always pursues his or her self-interest. The accumulation and processing of information and the formation of expectations occur efficiently, yielding possible outcomes (of total wealth) and corresponding possibilities.
A few other arguments, in addition to the above, include:
- Though some investors may not be rational, their trades are random, and thus cancel each other out without much effect on the overall prices.
- Irrational investors are met in the market by rational ones who are willing to take chances, thereby eliminating mispricing.
Forms of Efficiency
The EMH considers efficiency in three different forms based on the type of information. The details of the various forms of efficiency are provided in table.
Rationality can mean that agents receive new information so as to update their beliefs correctly. Based on their beliefs, agents make choices about securities that are normatively acceptable.
The exposition of EMH is displayed in Figure. The EMH has been subjected to a number of tests ever since it was propounded by Fama. The tests got a boost with the evolution of a new methodology known as Event Study. In Event Study, a sample of similar events that occurred in different companies at various points of time is obtained.
The average impact of these events on the stock price is then determined. Results indicated that the outcome depended on the efficiency of the market and the anticipation of the event by the market. Further, in consistence with the semi-strong form of market efficiency, many studies established that markets reacted quickly to new information. Studies on the performance of professional investors pointed towards the strong form or market efficiency.
The two main assumptions regarding finance theory so far discussed can be summarised as follows:
- Market participants are rational: Market participants aim at maximisation of positive function or utility, and minimisation of a negative function— cost or risk. They are well-informed and are capable of processing fresh data correctly and rapidly.
- Financial markets are efficient: The financial assets are perfect substitutes, and their current prices reflect all the available information accurately. The price is equal to the fundamental or intrinsic value, and is equal to the discounted sum of expected future cash flow. Due to this, financial assets can neither be overvalued nor undervalued. They are always traded at their fair values.
Misconceptions About the Efficient Markets Hypothesis
The efficient markets hypothesis has often been misunderstood. The common misconceptions about the efficient markets hypothesis are stated below along with the answers meant to dispel them.
| Misconception | Answer |
|---|---|
| The efficient markets hypothesis implies that the market has perfect forecasting abilities. | The efficient markets hypothesis merely implies that prices impound all available information. This does not mean that the market possesses perfect forecasting abilities. |
| As prices tend to fluctuate, they would not reflect fair value. | Answer Unless prices fluctuate, they would not reflect fair value. Since the future is uncertain, the market is continually surprised. As prices reflect these surprises, they fluctuate. |
| Inability of institutional portfolio managers to achieve superior investment performance implies that they lack competence. | In an efficient market, it is ordinarily not possible to achieve superior investment performance. Market efficiency exists because portfolio managers are doing their job well in a competitive setting. |
| The random movement of stock prices suggests that the stock market is irrational. | Randomness and irrationality are two different matters. If investors are rational and competitive, price changes are bound to be random. |
Criticism of Efficient Market Hypothesis (EMH)
The EMH has been criticised on several counts. Some of the criticisms are as follows:
- In EMH it is assumed that investors make decisions based on the rational expectations. According to this hypothesis, all investors make investment decisions based on the same expectations. This notion has been questioned by many.
For it is pure common sense that security markets and trading would not be possible if all investors had the same level of expectations. Trading in stocks take place just because one investor creates a sales position based on his or her expectation that prices of the stock would drop. The buyer in turn buys on the pretext that prices of the particular stock would increase. Thus occurs trading in a particular stock. - The assumption of EMH that all participants have equal access to information is also questionable, as it is most unlikely.
- Similarly, the US stock market crash in October 1987, followed by the unexplained increase of real estate prices during the period 2000 to 2005, the high degree of volatility experienced in the markets during 2008, etc., are all instances that have cast serious apprehensions on the rational behaviour of investors.
These apprehensions made experts and researchers to focus their attention on the impact of human emotions, like greed, biases, irrational decision making, etc., on investment decisions. They considered the influence of human emotions on decision making to be a definite possibility. Thus, experiences and studies pointed towards the fact that investors neither behave rationally nor consider all the available information in the process of decision making. - Market imperfections like delay in information and transaction costs are unexplained.
- Efficient market hypothesis deals with absolute price changes but not the relative price changes of the stocks.
- Random movement of stock prices does not indicate the direction of movement.
