The Efficient Markets Hypothesis

The efficient markets hypothesis (EMH), popularly known as the Random Walk Theory,
is the proposition that current stock prices fully reflect available information about the
value of the firm, and there is no way to earn excess profits, (more than the market overall), by
using this information. It deals with one of the most fundamental and exciting
issues in finance – why prices change in security markets and how those changes take
place. It has very important implications for investors as well as for financial managers.
Many investors try to identify securities that are undervalued, and are expected to
increase in value in the future, and particularly those that will increase more than others.
Many investors, including investment managers, believe that they can select securities
that will outperform the market. They use a variety of forecasting and valuation
techniques to aid them in their investment decisions.
The efficient markets hypothesis (EMH) suggests that profiting from predicting price
movements is very difficult and unlikely. The main engine behind price changes is the
arrival of new information. A market is said to be “efficient” if prices adjust quickly and,
on average, without bias, to new information. As a result, the current prices of securities
reflect all available information at any given point in time. Consequently, there is no
reason to believe that prices are too high or too low. Security prices adjust before an
investor has time to trade on and profit from a new a piece of information.
The key reason for the existence of an efficient market is the intense competition among
investors to profit from any new information. The ability to identify over- and underpriced
stocks is very valuable (it would allow investors to buy some stocks for less than
their “true” value and sell others for more than they were worth). Consequently, many
people spend a significant amount of time and resources in an effort to detect "mis-priced"
stocks.
Naturally, as more and more analysts compete against each other in their
effort to take advantage of over- and under-valued securities, the likelihood of being able
to find and exploit such mis-priced securities becomes smaller and smaller. In
equilibrium, only a relatively small number of analysts will be able to profit from the
detection of mis-priced securities, mostly by chance. For the vast majority of investors,
the information analysis payoff would likely not outweigh the transaction costs.
The most crucial implication of the EMH can be put in the form of a slogan: Trust market
prices! At any point in time, prices of securities in efficient markets reflect all known
information available to investors. There is no room for fooling investors, and as a result,
all investments in efficient markets are fairly priced, i.e. on average investors get exactly
what they pay for. Fair pricing of all securities does not mean that they will all perform
similarly, or that even the likelihood of rising or falling in price is the same for all
securities. According to capital markets theory, the expected return from a security is
primarily a function of its risk. The price of the security reflects the present value of its
expected future cash flows, which incorporates many factors such as volatility, liquidity,
and risk of bankruptcy.
However, while prices are rationally based, changes in prices are expected to be random
and unpredictable, because new information, by its very nature, is unpredictable.
Therefore stock prices are said to follow a random walk.
Three Versions of The Efficient Markets Hypothesis.
The efficient markets hypothesis predicts that market prices should incorporate all
available information at any point in time. There are, however, different kinds of
information that influence security values. Consequently, financial researchers
distinguish among three versions of the Efficient Markets Hypothesis, depending on what
is meant by the term “all available information”.
Weak Form Efficiency.
The weak form of the efficient markets hypothesis asserts that the current price fully
incorporates information contained in the past history of prices only. That is, nobody can
detect mis-priced securities and “beat” the market by analyzing past prices. The weak
form of the hypothesis got its name for a reason – security prices are arguably the most
public as well as the most easily available pieces of information. Thus, one should not be
able to profit from using something that “everybody else knows”. On the other hand,
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.
Semi-strong Form Efficiency.
The semi-strong-form of market efficiency hypothesis suggests that the current price
fully incorporates all publicly available information. Public information includes not
only past prices, but also data reported in a company’s financial statements (annual
reports, income statements, filings for the Security and Exchange Commission, etc.),
earnings and dividend announcements, announced merger plans, the financial situation of
company’s competitors, expectations regarding macroeconomic factors (such as inflation,
unemployment), etc. In fact, the public information does not even have to be of a strictly
financial nature.
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. Semi-strong
efficiency of markets requires the existence of market analysts who are not only
financial economists able to comprehend implications of vast financial information, but also
macroeconomists expert’s attempt at understanding processes in product and input
markets.
Arguably, acquisition of such skills must take a lot of time and effort. In
addition, the “public” information may be relatively difficult to gather and costly to
process. It may not be sufficient to gain the information from, say, major newspapers and
company-produced publications. One may have to follow wire reports, professional
publications and databases, local papers, research journals etc. in order to gather all
information necessary to effectively analyze securities.
Strong Form Efficiency
The strong form of market efficiency hypothesis states that the current price fully
incorporates all existing information, both public and private (sometimes called inside
information). The main difference between the semi-strong and strong efficiency
hypotheses is that in the latter case, nobody should be able to systematically generate
profits even if trading on information not publicly known at the time. In other words, the
strong form of EMH states that a company’s management (insiders) are not able to
systematically gain from inside information by buying company’s shares ten minutes
after they decided (but did not publicly announce) to pursue what they perceive to be a
very profitable acquisition. Similarly, the members of the company’s research
department are not able to profit from the information about the new revolutionary
discovery they completed half an hour ago. 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. Not surprisingly, though,
empirical research in finance has found evidence that is inconsistent with the strong form
of the EMH.
Implications of Market Efficiency for Investors
Much of the existing evidence indicates that the stock market is highly efficient, and
consequently, investors have little to gain from active management strategies. Such
attempts to beat the market are not only fruitless, but they can reduce returns due to the
costs incurred (management, transaction, tax, etc).
Investors should follow a passive investment strategy, which makes no attempt to beat
the market. This does not mean that there is no role for portfolio management. Returns
can be optimized through diversification and asset allocation, and by minimization of
investment costs and taxes.
In addition, the portfolio manager must choose a portfolio
that is geared toward the time horizon and risk profile of the investor. The appropriate
mixture of securities may vary according to the age, goals, tax bracket, employment, and
risk aversion of the investor.