I’m gonna talk about Efficient Market Hypothesis.
Efficient Market Hypothesis, EMH.
It is also called Efficient Market Theory. EMH states that share prices fully reflect
Efficient Market Hypothesis (EMH) all information, which means when there is a good news, share price will go up.
But if there is a bad news, share price will drop.
Stocks are always traded at fair value, making it impossible for investors to
purchase undervalued stocks, or sell stocks for inflated prices.
In other words, it should be impossible to outperform the
market through expert stock selection or market timing.
Whoever is trying to forecast the share price to go up or down, their forecast will fail.
The only way an investor can obtain higher returns is by purchasing riskier investments.
Reaction of Stock Price to New Information in Efficient & Inefficient Markets
However, the market is not always efficient. Let’s compare the reaction
of stock price to new information in both efficient and inefficient markets.
Under efficient market reaction, when there is a good news, the price instantaneously adjusts to
and fully reflects new information. There is no tendency for subsequent increases and decreases.
But sometimes there will be a delayed reaction. It happens when the price partially adjusts to
the new information. For example, eight days elapse before the price completely reflects.
the new information. In other words, investors take eight days to respond to the good news.
Another extreme is overreaction and correction.
It happens when the price over-adjusts to the new information. It overshoots the new price
and subsequent corrections. In other words, investors overly react to the good news.
Three Forms of Market Efficiency
As such, we have three forms of market efficiency.
First, strong form of capital market efficiency. It means, current prices reflect all information,
including historical, public, and private information that can possibly be known to anyone.
So, there is no information that allows investors to consistently earn abnormally high returns.
Even insider information is of little use.
But, according to empirical evidence, markets are not strong-form efficient.
Second, semi-strong form of capital market efficiency. It means, current prices reflect
all publicly available information. So, abnormally large profits cannot be
Earned consistently using public information. Fundamental analysis is of little use.
However, if the market is semi-strong-form efficient, insider information or private
information may help in making abnormal profits. But, insider trading is illegal.
Third, weak form of capital market efficiency. It means, current prices reflect only the information.
contained in past prices. So, past data on stock prices are of no use in predicting future stock prices.
price changes. Technical analysis is of little use. If the market is weak-form efficient,
investors may make abnormal profits by conducting fundamental analysis.
According to empirical evidence, markets are generally weak-form efficient in most countries.
As a summary, weak form includes all past information, semi-strong form includes
all public information, whilst strong form includes all relevant information.
Under strong-form efficiency, no investor should be able to earn abnormal return.
Under semi-strong- and weak-form efficiency, no investor can consistently earn abnormal return.
If sometimes investors earn abnormal return, it’s still possible.
Random Walks and Efficient Markets
Random walks and efficient markets have some connections.
Random Walk Hypothesis argues that stock price movements are random and unpredictable,
so there is no way to know where prices are headed.
Studies of stock price movements indicate that they do not move in neat patterns.
It is unlikely to find a fixed pattern or equation for stock price movements.
When new information arrives, prices react instantaneously to it.
Since new information cannot be predicted, it would arrive at random points in time.
Therefore, stock price movements would be random as well.
This could be an indication that markets are
highly efficient and respond quickly to the changes in the current situation.
Assumptions of EMH
To have an efficient market, it is assumed that,
There are many knowledgeable investors active in analyzing and trading stocks.
Information is widely available to all investors, and it is free and easy to obtain information.
Events, such as labor strikes or accidents, tend to happen randomly.
Investors react quickly and accurately to new information, causing prices to adjust.
Implications of EMH
The following are the implications of EMH.
First, in an efficient capital market, the transfer of assets occurs with little
