EFFICIENT MARKET HYPOTHESIS

Efficient Market Hypothesis

Efficient Market Hypothesis

Introduction

Efficient market hypothesis is a theory originally developed in the 1960s by E. F. Fama, M. C. Jensen, & R. Roll. The hypothesis states that it is impossible to beat the stock market because all prices and information on the market are already incorporated in the price of a stock. Because a market is efficient, it incorporates all the relevant information instantaneously before an investor or speculator.

The efficient market hypothesis theory is a well-studied and documented theory in economics. There is widespread disagreement and controversy on this theory because some economists and investors believe that one can beat the market by mathematical trading and by building mathematical models. Some investors believe that by using charting (a form of technical analysis) one can predict the stock price.

The efficient market hypothesis describes three forms of market efficiency:

Weak-Form Efficiency

The weak form states that the price of an asset incorporates all past or historical financial information about that stock. In order words, market efficiency hypothesis (EMH) states that the stock returns are uncorrelated and have a constant mean. The efficient market hypothesis theory is a well-studied and documented theory in economics. Some investors believe that by using charting (a form of technical analysis) one can predict the stock price. The efficient market theory, however, has an exception; that is, one can beat the market if one has insider information on the company stock. Similarly, a market is measured weak form efficient if current prices fully reflect all information contained in historical prices, which implies that no investor can formulate a trading rule based exclusively on past price patterns to earn abnormal returns.

Semi-Strong Efficiency

The semi-strong states that all publicly available information are incorporated in the price of the stock. In other words, a market is semi strong efficient if stock prices instantaneously reflect any new publicly available information and Strong form efficient if prices reflect all types of information whether available publicly or privately (Fama, 1965, p. 34).

Strong-Form Efficiency

The burly form states that the price of an asset incorporates all information from both public and independent sources (Fama, 1965, p. 34). This shows that an investor or a group of investors do not have monopolistic access to some confidential information relevant to the stock, so no investor or a group of investors should be able to make above average returns. The stalwart form EMH encompasses both the weak form and ...