What is the Efficient-Market Hypothesis?
The efficient-market hypothesis (EMH) is a theory of investment that says that the stock market always takes into account all information that is relevant about a company when pricing a stock. Therefore, all stocks are priced fairly at all times, and it is impossible to buy an undervalued stock or sell an overvalued one. The theory goes on to assume that an investor cannot outperform the market over the long term, and that they only way to increase returns is to commensurately increase risk. This theory is sometimes referred to as financial market efficiency.
Eugene Fama developed the efficient-market hypothesis in 1970. His study of finance and macroeconomics led him to assume a transparent market, in which all investors have access to all information about a company which could impact the stock price. The efficient-market hypothesis applies to both growth stocks and value stocks.
The efficient-market hypothesis has led to a number of models and theories which support, modify, or reject the EMH. Weak-form efficiency says that all previous prices of a given stock are reflected in today's price. Semi-strong form efficiency says that only non-public information can benefit an investor because all public information is accounted for in the stock price. Strong-form efficiency, like the EMH, says that all information, public or non-public, is represented in a stock's price; no investor can beat the market, even with so-called insider information.
The adaptive market hypothesis says that market efficiency is related to the number of competitors, available profit opportunities, and the ability of market participants to adapt. The most efficient market will have many competitors for few resources. Inefficient markets will have few participants but many resources.
When a stock fluctuates in conflict with the efficient-market hypothesis, it is possible to profit from the difference in the price. This is known as arbitrage. Arbitrage only exists in inefficient markets. The "random walk" model says that stock prices are unpredictable, and past performance cannot predict future returns.
Several theories address why, in an efficient market, stock prices sometimes move irrationally, known as a market anomaly. The dumb agent theory says that if each investor acts on his own, all information will be reflected in the stock price. When investors act together, panic and mob mentality can set in, causing price fluctuations. The noisy market hypothesis says that fluctuations in price and trading volume will confuse traders and result in trades that are not based on the efficient-market hypothesis.
@hamje32 - I’d agree with you and say that the adaptive market hypothesis is probably more realistic. Markets are always adapting to new inflows of information.
I believe that eventually the stock market gets it right, but that doesn’t necessarily mean that it gets it right the first time. How do you explain the stock market bubble of the gilded, Internet age?
There was no way those stock prices could be sustained, yet they kept climbing higher and higher – but not forever. Eventually there was what analysts called a “correction” and stocks collapsed, to their correct valuations. That’s the adaptive market in action.
I could never subscribe to any theory that stated it was impossible “buy an undervalued stock or sell an overvalued one,” as the article asserts about the efficient market hypothesis.
The fact is that this kind of thing happens all the time. Are there not “value” investors who buy stocks priced well below what analysis think are the proper valuations for those stocks? There most certainly are.
Conversely, are there not investors who sell stock shares that are overvalued, or IPOs with stock prices set in the stratosphere, only to come down drastically later? Again, I think that the obvious answer is yes.
I certainly believe that there are forms of efficient market hypothesis that would be valid in my opinion. For my part, just remove the “impossible” assertion from the efficient market theorem, and you will have something that is more reasonable.
I find studying stock price theories to be very interesting. I think there are bits of truth in all of the theories and it is wise to consider more than one.
Overall, I think there is quite a bit of truth to the efficient market hypothesis theory as far as the price of the stock goes.
I don't agree that you can't ever beat the market unless you assume more risk. There have been many times when I have had quite successful trades with very little risk involved.
This definitely doesn't happen all the time, but often enough to keep me investing in the stock market. As long as your profits are greater than your losses, you should be able to outperform the market more often than not.
Of all the theories mentioned in this article, I can really relate to the random walk model. When I worked in investments at a major bank, this is the philosophy we stressed with every customer.
I would not sell any kind of stock or investment product without knowing they clearly understood the risk. Anytime you are dealing with the stock market, you need to know that past performance never guarantees future results.
It can be helpful to look at the past history of a stock price and use that to make educated decisions, but nobody really knows which direction that stock price is going to go in the future.
I have a hard time totally going along with the efficient market hypothesis theory. If that were the case, why have so many people made a lot of money when they have access to insider information?
Yes, they often get caught, but they still made a lot of money off the trades from that information. If they had not prior access to this information, I don't think they would have had the same results.
I do believe that a lot of relevant factors are built in to the stock price, but there is a lot of non-public information that can have a dramatic impact on the price of a stock.
There are a lot of theories on the stock market out there, and I tend to agree with the efficiency market hypothesis theory.
When I look at the current price of a stock, I see that all the relevant factors I need to know at that time are included in the price of the stock.
That doesn't mean that the price cannot change drastically, even during the course of one trading day. It just shows that all relevant factors are included in the price, and if there are major price fluctuations, there is a reason for it.
It could be a major news announcement, earnings or a lot of buying or selling from a fund company or large investor. No matter what the reason is, the current stock price is going to reflect that.
Most any time I have tried to beat the market, it has not worked. I realize that stock market timing is crucial when it comes to successful trades, but trying to time the market to come out a winner every time usually has the opposite effect for me.
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