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What Is the Efficient Market Hypothesis Theory (EMH)?

The efficient market hypothesis theory (EMH) proposes that all important information relevant to the financial market, reflects in the stock price. Hence, only new information can affect the future price of the stock.

This implies that it is impossible for an investor to make accurate market decisions and beat the market consistently from a performance level only. According to this theory, the change in stock price is a result of new information about that company or industry.

Therefore, there will be a level playground for all investors except any of them with insider information which gives them an advantage. Again, since the only determiner to market price change is the new information, no analytical instrument can accurately predict or beat the market. 

History of Efficient Market Hypothesis

The efficient market hypothesis theory was formulated from the Ph.D. dissertation of Dr. Eugene Fama, an American Economist in 1970. Louis Bachelier, in his 1900 dissertation, proposed ideas on the concept of market efficiency.

He discovered that although the past, present, and even future events were reflected in market price, there was no symmetry with price changes. The rise of computers made the efficient market hypothesis more popular in the 1960s as it became easier to calculate market trends.

Much later in 1970, Dr. Eugene Fama published a review of the theory and postulations in favor of it.

Random-Walk Model

The random-walk model was first most clearly represented by Burton Malkiel in 1973. It is a mathematical model of the stock market, which explains that the stock market price evolves unpredictably. 

While the EMH attributes changes in market prices to available relevant information, the random-walk model postulates that anything, including irrelevant information, can affect market price. The early assumptions of this theory was seen in the works of Jules Regnault in 1863.

This became a spring ball for other related works by Louis Bachelier (1900), Paul Cooter (1964), Burton Malkier (1973), and Eugene Fama, the American economist credited with the efficient market hypothesis theory.

Why Is It Important?

This theory serves to eliminate the possibility of beating the market and to also reduce the possibility of arbitrage and overboard market returns. The more widely distributed market information is, the more efficient the market becomes.

Proponents of the weak form of efficient market hypothesis opt for index funds and propose passive portfolio management. 

Some investors believe in this theory and for you to start investing you have to understand other perspectives.

What Are the Assumptions of the Efficient Market Hypothesis?

There are several schools of thought in opposition or agreement with the theory. Nevertheless, the efficient market hypothesis postulates to be true under certain conditions or assumptions. 

Some of these assumptions include:

  • Stocks are priced and traded at a fair value
  • All investors have equal access to all available information, both private and public
  • Investors all interpret market information in a similar fashion
  • All investors are rational and hence, do not take risks.
  • It is impossible to get returns above-average market in the long run
  • Stock price fluctuate with an inconsistent pattern, making fundamental and technical analysis useless

The Three Degrees of EMH

There are three forms or degrees of the efficient market hypothesis. They serve to explain the different forms wherein the theory is true.

Weak-Form Efficiency

The weak-form efficiency states that all historical information is already reflected in the current stock price. This means that the current price of stocks is a reflection of all past available information. 

This efficiency degree explains that past performance cannot produce a change in the future price of stocks. Thus, it annuls the usefulness of the technical analysis.

Semi-Strong Efficiency

Semi-strong efficiency states that the present price of stocks is a reflection of their historic prices and present public information. This form portrays that the price of the stock quickly adjusts based on new information. 

Since this new information is present to all investors, it is impossible to make extra gains from fundamental analysis. Price changes would only be a reflection of new but private information.

Strong-Form Efficiency

This states that the stock market prices reflect all public and privately available information. Therefore, even though investors can take risks and make profits, they cannot consistently beat the market on a risk-adjustment basis over the long run.

What Are the Limitations of Efficient Market Hypothesis?

Investors have disputed EMH both theoretically and empirically. The imperfections in the financial market are due to cognitive behaviors such as overconfidence and how the investors process available information.

Empirical evidence has also not supported strong forms of the hypothesis. 

Overconfidence

Overconfidence bias is a cognitive bias where an investor exhibits an egotistical but misleading belief of their prowess, skills, and talent. The overconfident person thinks they are better or more skilled than others.

This bias produces an illusion of control where they believe that things will go exactly the way they’ve predicted.

Overreaction

Overreaction is seen with the emotional response investors make to new information. Investors can overreact to new information in the market, and this can impact the value of stocks, often disproportionately. Examples of this result in bubbles and crashes.

The good news in the market could lead to over-enthusiasm over stock but in the long run, investors realize that it wasn’t worth it. In the same vein, bad news can cause a decline in stock price only for investors to realize that that stock was undervalued.

This poses a limitation to the theory because the price change is not a result of new information but the investor’s emotional fluctuation.

Representative Bias

Also known as the representative heuristic bias. It is also a cognitive bias that attributes the similarity of two variables as the probability of an outcome. For example, a young man who studied accounting and is passionate about the guitar will likely be thought of as a banker and a member of a band, not just a banker.

As an investor, you should beware of this bias and learn to judge things strictly by their logical presentation rather than perceived appearance.

Information Bias

The financial market is largely inefficient because investors process information differently. Information bias talks about the distorted manner investors evaluate the information they access. 

Investors’ curiosity and financial goals influence their decisions as they negotiate a course of action. While an investor might consider undervalued stocks, another investor might assess stocks based on their growth potential.

These two approaches will produce different results.

Disproving Efficient Market Hypothesis Theory

Empirical analysis has had reasons to question the ideal nature of the efficient market theory. 

Asset Bubbles

Sometimes, investors purchase stocks based on the rising value of the stocks rather than the intrinsic fundamental return of the stock. This is termed asset bubbles.

Due to the rise in a stock’s price, it paints the delusional picture of a rise in its intrinsic value. Some of the greatest global economic contractions were a result of big asset bubbles and crashes.

The Great Recession of the late 2000s was a result of the U.S Housing Bubble. Following what might be termed the biggest bubble, the Dotcom Bubble, investors moved to invest in real estate a safer asset.

This caused a spike in the price of real estate to nearly double the amount between 1996 and 2006. Then came a steep decline within the next three years that brought down the value of real estate to one-third the price.

Asset bubbles often occur due to overreaction bias, and the bigger the bubble, the more it cripples the economy when it bursts.

2000s Financial Crisis

Jeremy Grantham, veteran investor and co-founder of GMO, made a rebuttal that the efficient market theory is responsible for the financial crisis witnessed in the 2000s. A strong opposer of the EMH and fiscal policy, Mr. Grantham announced that the theory played down the role of human irrationality and uncouth behavior in a bid for mathematical order and elegant models.

This, according to him, made financial leaders and the government unconscious of the effect that asset bubbles, lax controls, and harmful incentives had on the market. He blamed the misleading theory for the grave financial crisis witnessed in the 2000s including the Dotcom bubble of 2000-2003, The Great Recession of 2007-2009, and the oil price bubble of 2003-2009.

Transaction Costs

These are expenses that incur during the purchase or sales of a good or service. Transaction costs include time and labor, appraisal fees, government fees, and communication.

Transaction costs always changes pricing because they determine the net return on investment. As transaction costs diminish, for example in ease of communication, the price of goods and services among individuals also decreases

This disproved the theory, which is emphatic in the proposal that only new information creates price change.

Insider Trading

This is an illegal practice where one trades stocks due to private information they have become privy of. This creates an unfair advantage over other people who can only make their stock market choices based on public information.

Once again, this disproved the efficient market theory because insider trading, although illegal, gives investors the foothold to beat the market.

Bottom Line

Strong efficient market hypothesis is mostly idealistic since human behavior and fundamental analysis have faulted the reality of the theory. Although the market might seem unpredictable, it is still possible to predict and beat the market in the long run. Warren Buffet has proven this.

Make sure to consult with a financial advisor before you take any investment plan or purchase stocks. This will give you a better understanding of the market and help you invest wisely.