Efficient Market Hypothesis

`A market is efficient with respect to a particular set of information if it is impossible to make abnormal profits by using this set of information to formulate buying and selling decisions.’

Critical Analysis

When we invest money into the stock market we do it with the intention of generating a return on the capital invested. Many investors try not only to make a profitable return, but also to outperform, or ‘beat the market’. However, market efficiency - championed in the efficient market hypothesis (EMH) formulated by Eugene Fama in 1970, suggests that security prices instantly and fully reflect all available information and that it would not be possible for an investor to make consistent excess profits. When new information arrives in the market, investors on some occasion will make an abnormal return by being the first ones to trade on it and in other cases they will lose. On average investors will make a normal return and efficient markets will not allow investors to earn above-average returns without accepting above-average risks.

A well-known story tells of a finance professor and a student who come across a $100 bill lying on the ground. As the student stops to pick it up, the professor says, “Don’t bother—if it were really a $100 bill, it wouldn’t be there.” The story well illustrates what financial economists usually mean when they say markets are efficient. We believe that financial markets are efficient because they don’t allow investors to earn above average returns without accepting above average risks. In short, we believe that $100 bills are not lying around for the taking, either by the professional or the amateur investor. (Burton G Malkie, 2003)

There are three different levels of efficiency according to the type of information which is reflected in prices and they can be identified as weak, semi strong and strong. Under weak form efficiency, the current price reflects the information contained in all past prices, suggesting that... [continues]

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