What is the Efficient Market Hypothesis?
Updated: Jul 12, 2022
Since Eugene Fama’s “Efficient Capital Markets” (1970), the world of Financial Economics has been in constant debate over the Efficient Market Hypothesis (EMH). The EMH describes the market as one that prices securities as a perfect reflection of all available information. Underscoring the hypothesis is the idea that no investor is able to consistently beat the market using fundamental or technical analysis. Instead, the only method of obtaining higher returns is to take on higher risk.
The EMH hinges on three main assumptions. Firstly, that investors are rational. Secondly, even if investors are not fully rational, the idiosyncratic irrationality of individual market participants should cancel each other out. Lastly, if investors are in fact irrational in similar ways, then arbitrageurs or ‘smart money’ will serve as market correctors whenever there is mispricing. Together, these assumptions help explain how and why the markets are mean regressing. Additionally, with securities prices perfectly reflecting information including past information (weak form efficiency), present public information (semi-strong form efficiency) and inevitable soon to be leaked insider information (strong form efficiency), as well as the understanding that information is in fact random by nature, EMH is often associated with the idea of a “Random Walk.” Overall, this theory posits that the financial markets are so efficient and random that it is impossible to make consistent abnormal profits.
Eugene Fama (Born: Feb 14, 1939) is a distinguished Professor of Finance at the University of Chicago Booth School of Business. Often considered the father of Modern Finance, Fama is also the recipient of the Nobel Laureate in Economic Sciences in 2013.
Bibliography
Downey, L. (2022, June 27). Efficient market hypothesis (EMH). Investopedia. Retrieved June 28, 2022, from https://www.investopedia.com/terms/e/efficientmarkethypothesis.asp
Fama, E. F. (1970). Efficient capital markets: A review of theory and empirical work. The journal of Finance, 25(2), 383-417.
Malkiel, B. G. (2003). The efficient market hypothesis and its critics. Journal of economic perspectives, 17(1), 59-82.
Shleifer, A. (2000). Inefficient markets: An introduction to behavioural finance. Oxford University Press.