Efficient Market Hypothesis

Topics: Stock market, Stock, Fundamental analysis Pages: 10 (3114 words) Published: March 5, 2010
`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 charts and technical analysis that use past prices alone would not be useful in finding under valued stocks. In an efficient market no trader will be presented with an opportunity for making a return on a share that is greater than a fair return for the riskiness associated with that share through technical analysis.

The weak form efficiency is associated with the idea of a ‘random walk’ which suggests that past movement or trend of a stock price or market cannot be used to predict its future movement. The logic of the random walk idea is that if the flow of information is unhindered and information is immediately reflected in stock prices, then tomorrow’s price change will reflect only tomorrow’s news and will be independent of the price changes today. Since news is by definition unpredictable then resulting price changes must also be unpredictable and random (Burton G Malkie, 1973). The simple idea behind the weak form efficiency is that everyone in the market can see the history of prices, any predictable pattern will soon be exploited and the very process of trying to exploit it will eliminate the pattern. There are so many observers at work that if any information were contained in past price movements it would be impounded in the current price as a result of buying and selling and thus arbitrage would force prices to their efficient values. Especially with the rise of computerized systems which analyze stock movements, investments are becoming increasingly automated and computers can immediately process all available information, and even translate such analysis into an immediate trade execution. If there exists any past price information advantage it would be quickly eliminated by all such computers at work. Thus weak form efficiency tries to establish that an inexperienced purchase of a large, broadly based portfolio of securities produces returns the same as those purchased by a ‘technical analyst’ focusing over share price data and selecting shares on...

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