FINANCIAL MANAGEMENT

Efficient Market Hypothesis

Efficient Market Hypothesis

Part I: Three forms of market efficiency

Investors of the stock market make their investments not only in the hope of making profitable returns but also in the hope of beating the market. Eugene Fama in the year 1970 gave the famous Efficient Market Hypothesis (EMH). He suggests that price of a stock fully reflects all available information in the market. Therefore, it is impossible for an investor to beat the market since all investors have access to the same set of information available in the market.

There are three forms of market efficiency. These are weak, semi-strong, and strong (Howden 2009, p. 4).

Weak form

A weak form of market efficiency states that investors cannot beat the market in that current price of the stock fully incorporates all information from the preceding data. Hence, investors who make their investment decisions purely on the basis of information from the past cannot outperform the market.

Semi-strong form

A semi-strong form of efficiency suggests that the price of a stock reflects all publicly available information. Here investors cannot outperform the market based on fundamental or technical analysis.

Strong form

The strong form of market efficiency suggests that prices of stock fully reflect all information publicly available as well as all the private information. This is the strongest form of market efficiency. Hence, it is impossible for an investor to beat the market through insider trading.

Information here does not mean financial information only. It includes all information that can have an impact on the price of the stock such as news pertaining to significant political, social and economic events and investment research. Public information refers to the financial reporting requirements fulfilled by companies in the form of making the financial statements publicly available.

If some fund manager beats the market once in a while, it does not suggest that prices do not reflect all publicly and privately known information in that no investor can outperform the market on an ongoing basis. EMH responds to these profits by saying that prices are not always equal to the fair value (Whitman 2002, p. 2). Price valuation may result in overvalued or undervalued stocks. Any trade on the part of a fund manager to take advantage of a diversion from the fair value of the stock brings the stock's price back to its fair value. Fund managers fail to consistently outperform the market because the diversion from the fair value is a random phenomenon. Hence, any such profit is a result of mere luck. The law of profitability reinforces this claim as it suggests that all investors in the market cannot make the same return. Some will stay average while the other will make higher returns.

Part II: Efficient market hypothesis (EMH)

Before addressing the question whether or not markets are efficient, it is important to understand how markets become efficient at least in the theory, as given by Fama. Investors who believe that markets are inefficient have ...