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The Efficient Market Hypothesis (EMH) is a hypothesis for financial markets that reflect available information in regard to economic fundamentals (Peon, Antelo, Calvo, 2019). Studies show that the debate of the financial market hypothesis appears to be the most controversial when talking about all social sciences (Peon, Antelo, Calvo, 2019). This hypothesis can be difficult to understand and master. The hypothesis itself seems impossible as it is in reality “impossible” to beat the market. You can never know as market prices constantly change and react to new information that cannot be predicted.
This theory was first introduced by the French mathematician Louis Bachelier in the 1900s when he did his Ph.D. thesis on “The Theory of Speculation” and wrote on how stock prices continually varied in markets.
The Efficient-Market Hypothesis can show the framework/logic behind risk-based theories of asset prices. It is based on information. Say there is information that is available for all investors to use to determine the future value of a stock. If the price of the stock does not currently reflect that information, the investors can make trades on the stock. The price of the stock then moves until that piece of information is no longer available. This doesn’t imply that stock prices are completely unpredictable. Obvious events such as a financial crisis that is likely to come based on the current status of our country and culture are quite predictable to investors. The fundamental theorem of asset pricing describes how efficient markets are (or are not) linked to the random walk theory. The random walk hypothesis is a financial theory that says stock market prices grow and move in a random order (prices are random) and cannot be predicted by investors.
The book, Advances in Behavioral Finance has made major contributions as far as showing the progress of the efficient market hypothesis (EMH). Also, studies show that there are three forms of alternative paradigm when talking about the efficient market hypothesis. Firstly, there is a Weak form which means that “some market participants fail to fulfill economists’ notions of rational behavior, meaning that distortions, by and large, disappear quickly through the actions of arbitragers who employ correct pricing models” (Lee, p. 86). Secondly, there is Semi-strong form which means that “persistent analytical errors occur on so vast a scale that prices frequently diverge materially and for protracted periods from their correct levels” (Lee, p. 87). And thirdly, “Strong form which means “securities prices bear little relation to corporations’ financial performance. Rather, changes in market levels are driven largely by popular manias.” (Lee, p. 87).
The legitimacy of this hypothesis is difficult to discern as investors are unable to ever fully predict the market and yet can at times predict the market. Although it plays a big part in modern financial theory, it is still highly controversial and very often disputed. Some financial analysts believe it is incredibly pointless to continually seek undervalued stocks or try to predict stock trends through either means of fundamental or technical analysis. The only thing that would be secure is inside information which is illegal.
Reference:
Peón, D., Antelo, M., & Calvo, A. (2019). A guide on empirical tests of the EMH. Review of Accounting & Finance, 18(2), 268-295. https://doi.org/10.1108/RAF-02-2016-0031
Lee, C. (2008). Efficient Market Hypothesis (EMH): Past, Present and Future. Review of Pacific Basin Financial Markets and Policies, 11(2), 305–329. https://doi.org/10.1142/S0219091508001362
Zamokas, G., Grigonis, A., Babickaitė, L., Riškevičienė, V., Lasienė, K., & Juodžiukynienė, N. (2016). Extramedullary hematopoiesis (EMH) and other pathological conditions in canine spleens. Medycyna Weterynaryjna, 72(12), 768-772. https://doi.org/10.21521/mw.5598
Passage 2
Efficient Market Hypothesis: Outdated or Relevant?
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The EMH is one of the founding pillars of modern financial economic theory and has since its inception by Eugene Fama in 1970 been heralded, debated, and revised over time by academics and financial professionals alike. Fama posits in his groundbreaking theory at the time of its publishing on the basis that, "apart from occasional and very exceptional circumstances, financial markets are always in reality efficient (O'Sullivan, 2018, p.235)." From that assertion Fama further expanded his theory to specify that this would hold true in three different variants of efficiency, namely weak form, semi-strong form, and strong form market efficiency.
In the weakest form of economic efficiency, Fama outlines that all relevant information in terms of pricing assets is made publicly available already, and in essence investors cannot hope to make better returns than the market average as a result. This is where the random-walk theory. Asset prices can and will fluctuate from time to time, however, outside of fundamental analysis of the company and/or luck and possibly insider trading, outperforming the average return is unlikely in this variant of an efficient market.
Famas semi-strong form of market efficiency holds to the same general themes as that of the weak form, except that it contends that asset prices will reflect all past and current information made publicly available if not immediately, then very shortly thereafter, offering little opportunity again to “beat the market” return as an average. Finally, the strong form efficiency variant provides for the most restrictive environment for an investor to hope to beat normal market returns, where asset prices reflect all past and current information seamlessly, including that of insider information. Essentially, in this form of market efficiency trading is futile and any attempt in an effort to provide a higher-than-average return would be both irrational and fruitless.
EMH has not stood the test of time in terms of its accuracy to predict how financial markets behave. O’sullivan, 2018, is even more passionate in terms of EMH’s empirical testing failures where he writes “The EMH—at least in its strong and semi strong variants—can be seen by the most casual observer of financial markets to be blatantly falsified.” I would be inclined to agree with this statement, as evidenced throughout market events over the past 50 years since Fama first published his thoughts. Empirical evidence backs up these findings, contrary most of EMH. Mainly this can be proved by the fact that markets are hardly dormant, and perhaps most notably the fact that asset markets have been known for their boom and bust cycles, most recently the dot.com bubble, as well as the near financial worldwide institutional collapse in 2008.
I believe these events to largely poke major holes in the idea that markets are perfectly efficient, or even nearly so. Simply ignoring the behavioral aspect of humans doing a large part of the trading in the financial markets would be turning a blind eye to what we have learned to be true, at least partially, in the field of behavioral finance since Fama published the EMH some 50 years ago. Finally, while I wouldn’t discount Famas EMH in its entirety and discount its merits, as the cited article seems to be trying to do, I would argue that how financial markets behave in reality is more of a blend between some market efficiency based on fundamental/technical analysis as well as behavioral finance theories. The evidence to choose one or the other as the primary end all be all financial theory would be an ignorant decision in my opinion.
References
O’Sullivan, P. (2018). The Capital Asset Pricing Model and the Efficient Markets Hypothesis: The Compelling Fairy Tale of Contemporary Financial Economics. International Journal of Political Economy, 47(3/4), 225–252. https://doi.org/10.1080/08911916.2018.1517462
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