The efficient market hypothesis

The term “Efficient Market” was used for the first time by the American economist Eugene Fama(1939-) in his famous article published in 1970 “Efficient Capital Market: a review of theory and empirical works”.
The main idea behind this theory is that it is impossible for investors to outperform the market by looking for undervalued stocks or trying to predict the trends of the market because stocks always trade at their fair value at exchange and the share prices reflect all the available information.

Share prices always incorporate and reflect all the relevant information and thus, since the investment is based on the publically available data, it is systematically not possible to beat the market over time. Considering that the old information is already incorporated in the prices and the news is by definition unexpected and random, stock returns are hard to forecast.

When new information arises it’s spread very quickly and incorporated into the prices of shares without delay and this makes that the buyers have just as much info as the sellers, which means that a stock is just as likely to outperform the market as it is to underperform.
In that case, neither technical analysis( the study of past stock prices in order to predict future prices) nor even fundamental analysis( the analysis of financial data to help investors select undervalued stocks) would help investors to achieve alpha generations.

As Burton G. Malkiel said in his article “The Efficient Market Hypothesis and Its Critics”, an investor can be lucky an buy a stock that brings him huge short term profits but over the long term it is realistically not possible for him to achieve a return that is sustainably higher than the market average.
According to Malkiel, the efficient market hypothesis is associated with the ” Random Walk ” idea that suggests that changes in stock prices are independent of each other, therefore it assumes that the past movement or trend of a stock price can not be used to predict its future movement. The logic behind this idea is that the flow of information is immediately reflected in stock prices, this implies that tomorrow’s changes will reflect only tomorrow’s news and will be independent of today’s price movements, news is unpredictable by definition, thus price changes must be unpredictable and random.

Economists who believe in efficiency do so because they see markets as successful devices for reflecting new information rapidly and accurately. They also believe that financial markets are efficient because they don’t allow investors to earn above-average risk-adjusted returns. According to them, the only way to earn above-average returns is to take above-average risks

By the start of the twenty-first century, the intellectual dominance of the efficient market hypothesis had become far less universal and it’s no longer taken for granted. Many academics have begun to express their doubts about this theory and even went to provide arguments on its invalidity. Many financial economists and statisticians began to believe that stock prices are at least partially predictable.
A new strain of economists highlighted psychological and behavioral elements of stock-price determination, and they came to believe that future stock prices are somewhat predictable based on past stock price patterns as well as certain “fundamental” valuation metrics. Moreover, many of these economists were even making the far more argumentative claim that these predictable patterns enable investors to earn excess risk-adjusted rates of return. This view derives its strength from the fact that some investors have actually beaten the market, like Warren Buffett who made billions of dollars from the stock market with a strategy that focuses on undervalued stocks.
Efficient market hypothesis opponents claim that there are many other factors that intervene in the market that lead to inefficiencies such as information asymmetries, a lack of buyers and sellers, high transaction costs or delays, and human emotion.

Although it is largely questioned and constitutes a subject of polemic among economists and academics, it is still considered a cornerstone of modern financial economics.



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