Efficient market hypothesis

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The Efficient Market Hypothesis |
The Weak Form |
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5/2/2011 |

The Efficient Market Hypothesis

The Efficient Market Hypothesis is one of the most prevalent theories that currently exist regarding the stock market. The theory was originally introduced by Eugene Fama in his 1960s thesis and became widespread and popular over the next 40 years. The EMH theory states that allsecurities on the market are appropriately priced at any point in time and that there is an almost instant adjustment to new information within the market. During these 40 years several variants of the theory have developed based around the belief or disbelief in the following three aspects of security price prediction: technical analysis, fundamental analysis, and inside information. Technicalanalysis is the analysis of historic data and charts in order to identify past trends in the market that can be utilized to predict future prices of securities. It states that there is a strong correlation between historic prices and future prices. Fundamental analysis is the valuation of a security on the basis of fundamental factors of the company as well as the industry. With this type ofanalysis a detailed look is taken at the company’s financial statements and current trends for the industry it is in. Malkiel states in his book A Random Walk Down Wall Street, that followers of technical analysis “believe the market is only 10 percent logical and 90 percent psychological.” Fundamental analysts, however, believe “that the market is 90 percent logical and only 10 percentpsychological” (101). Finally, inside information involves the use of privileged information about a company, not available to the public, in order to make smart investment decisions (Block).
The efficient market hypothesis asserts that neither inside information, nor fundamental and technical analysis, will benefit you when making investing decisions and that it is not, in fact possible, to make aboveaverage returns on a risk adjusted bases as a result of any sort of strategy. Any time an above average return does occur within the market it is solely due to an anomaly because the market as a whole is always correct and accurate (Russel). The intense competition between so many investors all conducting in depth analysis attempting to discover over or undervalued stocks makes the probability ofactually finding such securities highly unlikely. The efficient market hypothesis has developed into three main forms over time. These forms are the strong form, the semi-strong form, and the weak form (Block).
The Strong Form
The strong form advocates that the EMH is fully correct and that no amount of information or analysis will produce above normal returns after being adjusted for risk.Thus, anyone who does any sort of analysis is simply wasting their time because the market prices already reflect all information including insider information. This form asserts that even if insider information results in high returns the consequences for insider trading are inevitable and will counteract any gains. In the event that someone is able to generate above normal returns it isconsidered an anomaly relating to some additional factor and neither predictable nor repeatable. Advocates of the strong EMH theory will look for securities that will generate expected returns based on basic investing principles without taking on significant risk or expecting above average returns. The “buy and hold” method is generally expected to be the best strategy since short term gains areunlikely in an efficient market. An investor can expect the best returns by investing in index funds that match the performance of the major indexes (Simple Stock Investing).
The Semi-Strong Form
The semi-strong form of EMH believes that insider information is not already included in the price of a security and can, therefore, be used to create above average returns. However, it still holds that...