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Efficient Market Hypothesis

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13 views14 pages

Efficient Market Hypothesis

Uploaded by

Jessi Mindset
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© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Efficient Market Hypothesis

Introduction
 Random walk hypothesis
 The efficient market hypothesis (EMH) is an idea partly
developed in the 1960s by Eugene Fama.
 It is an investment theory that states it is impossible to "beat
the market" because stock market efficiency causes existing
shares to always incorporate and reflect all relevant
information.
 According to the EMH, stock always trade at their fair value on
stock exchanges, 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 the higher
returns is by purchasing riskier investments.
An efficient capital market is a market that is
efficient in processing information.
In other words, the market quickly and
correctly adjusts to new information.
In an information of efficient market, the
prices of securities observed at any time are
based on “correct” evaluation of all
information available at that time.
Therefore, in an efficient market, prices
immediately and fully reflect available
information.
Definition
• "In an efficient market, competition
among the many intelligent participants
leads to a situation where, at any point
in time, actual prices of individual
securities already reflect the effects of
information based both on events that
have already occurred and on events
which, as of now, the market expects to
take place in the future. In other words,
in an efficient market at any point in
time the actual price of a security will
be a good estimate of its intrinsic
The Efficient Markets
Hypothesis
The Efficient Markets Hypothesis (EMH) is
made up of three progressively stronger
forms:
Weak Form
Semi-strong Form
Strong Form
The EMH Graphically
All historical prices and
 In this diagram, the returns
circles represent the Strong Form
amount of information
that each form of the
Semi-Strong
EMH includes.
 Note that the weak form
covers the least amount Weak Form
of information, and the
strong form covers all
information.
 Also note that each
successive form includes
Allthe previous ones.
information, public and
private All public information
The Weak Form
 The weak form of the EMH says that past prices,
volume, and other market statistics provide no
information that can be used to predict future prices.
 Weak because security prices are the most easily
available piece of information.
 Many financial analysts attempt to generate profits
by studying exactly what this hypothesis asserts is
of no value - past stock price series and trading
volume data. This technique is called technical
analysis.
 Prices should change very quickly and to the correct
level when new information arrives (see next slide).
 This form of the EMH, if correct, repudiates technical
analysis.
The Semi-strong Form
 The semi-strong form says that prices fully
reflect all publicly available information(even
those reported in the financial statements of
the companies) and expectations about the
future.
 This suggests that prices adjust very rapidly to
new information, and that old information
cannot be used to earn superior returns.
 The assertion behind semi-strong market
efficiency is still that one should not be able to
profit using something that “everybody else
knows” (the information is public).
Nevertheless, this assumption is far stronger
than that of weak-form efficiency.
 The semi-strong form, if correct, repudiates
The Strong Form
The strong form says that prices fully reflect all
information, whether publicly available or not.
Even the knowledge of material, non-public
information cannot be used to earn superior
results.
The rationale for strong-form market efficiency is
that the market anticipates, in an unbiased
manner, future developments and therefore the
stock price may have incorporated the information
and evaluated in a much more objective and
informative way than the insiders
Most studies have found that the markets are not
efficient in this sense.
Summary of Tests of the EMH
 Weak form is supported, so technical analysis
cannot consistently outperform the market.
 Semi-strong form is mostly supported , so
fundamental analysis cannot consistently
outperform the market.
 Strong form is generally not supported.
 Ultimately, most believe that the market is
very efficient, though not perfectly efficient. It
is unlikely that any system of analysis could
consistently and significantly beat the market
(adjusted for costs and risk) over the long run.
Implications of Efficient Markets

Technical Analysis – Technical analysis uses


past patterns of price and the volume of
trading as the basis for predicting future
prices. Evidence suggests that prices of
securities are affected by news. Favourable
news will push up the price and vice versa.
It is therefore appropriate to question the
value of technical analysis as a means of
choosing security investments.
 Fundamental Analysis – Fundamental Analysis
involves using market information(such as earnings ,
dividends , accounting ratios) to determine the
intrinsic value of securities in order to identify those
securities that are undervalued. However semi strong
form market efficiency suggests that fundamentals
analysis cannot be used to outperform the market. In
an efficient market, equity research and valuation
would be a costly task that provided no benefits. The
odds of finding an undervalued stock should be
random (50/50). Most of the time, the benefits from
information collection and equity research would not
cover the costs of doing the research.
Optimal Investment Strategy - For
optimal investment strategies, investors
should follow a passive investment
strategy, which makes no attempt to beat
the market. Investors should not select
securities according to their risk aversion
or tax positions . In an efficient market, it
would be a superior strategy to have a
random diversification across securities,
carrying little or no information cost and
minimal execution costs in order to
optimise the returns. There would be no
value added by portfolio managers and
 The overall assumption is that no investor
is able to generate an abnormal return in
the market. If that is the case, an investor
can expect to make a return equal to the
market return. An investor should thus
focus on the minimizing his costs to invest.
To achieve a market rate of return,
diversification in a numerous amounts of
stocks is required, which may not be an
option for a smaller investor. As such, an
index fund would be the most appropriate
investment vehicle, allowing the investor to
achieve the market rate of return in a cost

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