Efficient markets hypothesis

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This article explains the concept of the Efficent Markets Hypothesis (EMH). It is incomplete and welcomes contribution.

The Efficient Markets Hypothesis is perhaps the most prevalent and well-known market theory in the world. It claims that market prices fully reflect all available information and that it is not possible to consistently and purposefully outperform a given market using any information that is already known to the market. Essentially, this implies that arbitrage opportunities are impossible to consistently identify and exploit. An old joke that illustrates this notion goes as follows:

Two investors are strolling down the street. They come upon a $100 bill lying on the ground, and as one of them reaches down to pick it up, the other remarks, "Don't bother - if it was a genuine $100 bill, someone would have already picked it up."

The hypothesis hinges on the availability and speedy transfer of information. Though it may seem ridiculous for the second investor to discard the $100 bill, if there are a thousand other investors who have already walked by it, noticed it, and discarded it, it is in fact quite reasonable for the second investor to discard it as well. Even more compelling would be if there were a huge billboard pointing to the bill, and saying "Free $100, here."

Certainly there are thousands of investors on the stock market, and though there are not billboards, there are hundreds of investment sites and newspaper articles advising their readers on "hot stocks." This is the most important consequence of the Efficient Market Hypothesis for investors: that all investment tips are essentially useless, having already been reflected in the price of the stock.

History

The EMH was developed independently by two economists in the mid-1960s: Professor Eugene Fama from the University of Chicago and Paul Samuelson from MIT.

Criticism

Economists who disagree with the hypothesis mostly attack it on the grounds of the speed which information is supposed to reach investors. They argue that it takes time for new information to find its way into the papers and websites.

These economists are certainly in the minority, and as the speed with which information disseminates increases, their position loses more and more of its base.

EMH has also been consistently empirically contradicted (though not formally) by Value Investing as well as historic events, such as the 1987 stock market crash, in which the DJIA fell by over 20% in a single day. Essentially, though the markets may often be efficient, they are not necessarily always efficient.

Competition

Behavioral finance has long contended against the EMH, but has more recently formalized its theories in the form of the Adaptive Markets Hypothesis (AMH).

References

  1. http://en.wikipedia.org/wiki/Efficient_market_hypothesis
  2. http://web.mit.edu/alo/www/Papers/EMH_Final.pdf
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