Efficient Market Hypothesis - Explained
What is the Efficient Market Hypothesis?
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Table of ContentsWhat is the Efficient Market Hypothesis?How Does the Efficient Market Hypothesis Work?
What is the Efficient Market Hypothesis?
The efficient market hypothesis (EMH) is a financial market theory which states that the market price of a financial asset reflect all the available information. An efficient market shows all the market information available at a period of time to investors or other market participants. The Efficient Market Hypothesis (EMH) is an investment of financial theory that created in the 1970s by Eugene Fama. It posits that all market information are reflected by the price of assets. It also maintains that stocks are priced according to their innate properties which are known to market participants. The Efficient Market Hypothesis (EMH) just like any other financial theory presents ideas that give explanations to investment in the modern world and how the market works at large. However, EMH fails to give explanations to stock markets behavior and this is regarded as a downside.
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How Does the Efficient Market Hypothesis Work?
The efficient market hypothesis (EMH) assumes that all the available past information is already incorporated into a stocks price. This means that an investor cannot earn risk-adjusted returns or alpha with technical or fundamental analysis. A such, it is the only inside information that makes it possible to achieve returns in excess of market expectations. If investors want to earn higher rates of return, they can only do so by investing in riskier financial assets. Someone ascribing to the EMH would say that passively investing in securities (rather than active trading) is the best market strategy. The EMH is a highly-debated concept. The proponents of efficient market hypothesis cite the results of investors, such as Warren Buffett, who have consistently outperform the market. Opponents of the concept focus on market dips, such as the crash of 1987, to argue that prices can significantly deviate from their fair market values. A general perception of the efficient market hypothesis is that all market participants perceive market information in an exact manner, which is not true. Due to the fact that different investors participate in the stock market with different purposes or intentions, they perceive and interpret market information differently. Another problem with EMH is the assumption that investors perceive information in equal manner means that they will all have equal returns. That is, an investor cannot realize higher profit that another investor if they both have the same amount for investment. The third problem with EMH is that an investor cannot earn an investment return that exceeds the performance of the market or the average annual returns of other investors. Hence, the overall level of corporate profitability or losses in the stock market affect individual investors. Stock react to new prices or new investment information released in the market steadily, it requires some time for it to respond. Since it is impossible for a market to be efficient at all times, the Efficient Market Hypothesis (EMH) is also not efficient at all times. For instance, its failure to provide information on how much time prices need to revert to an impartial value. Also, whether EMH makes provision for random events and future eventualities that might not be predictable is an area of concern. Since there are certain inefficiencies of the EMH theory, perfect market efficiency might be impossible. Despite that there are certain problems attributed to the efficient market hypothesis, the theory is still relevant to the growth of the market. The computerized systems used in the analysis of stock investments have called for mathematical methods in the analysis. The use of analytical machines and mathematical methods is not universal. However, regardless of the high involvement of computers in the analysis of stock investments, the role of investors (real humans) in the decision making in stock market cannot be sidelined. Since humans participate in the decision making process, errors are inevitable. Despite humne errors that occur in decision-making, the success of stock market investment is largely based on the skill of investors. When used in investment or trading, technical analysis involves the use of price trends and previous trading patterns in identifying trading opportunities and predicting future occurrences. Unlike technical analysis that relies on the data of past prices or past results, EMH maintains that past results are not useful in outweighing the market. Because of this, EMH disregards technical analysis as a means to generate investment returns. EMH does not only negates technical analysis but also fundamental analysis. EMH maintains that all the market information such as security price, abnormal return on stock cannot be made available to market participants at any given time using the fundamental analysis method. The Efficient Market Hypothesis (EMH) is a theory that holds that market can be tagged efficient if all information such as security prices and returns are fully reflected and made available to market participants. Portfolio management reflects how an individual investor diversifies and manages his securities as well as the constraints entailed. Usually, the goal of portfolio management is to outperform other investors in the market through unique ideas and this goal is not permissible or achievable under EMH. This is because, EMH does not allow an investor to outperform other investors or earn above the average returns. Hence, with regard to EMH, portfolio management should only focus on achieving average returns and not otherwise. In line with the Efficient Market Hypothesis (EMH), investors are expected to make returns equal to market return and not above. In order to enable investors achieve market rate of return in an effective way, investors are encouraged to invest in index funds. Basically, an index fund is designed to follow market rules so that the end goal of the market can be achieved. An index fund can also be an exchange-traded fund in which the performance of the fund is closely monitored in a way that it reflects the benchmark index. For investors to achieve market rate of returns, costs to invest must be minimized, diversification in a numerous amounts of stocks is also required, which is why they invest in index funds. It is quite impossible for the market to be efficient at all times. That means full efficiency of the market is unattainable. Nevertheless, for a greater market efficiency to be achieved, there are certain criteria that must be met, these are;
- Investors must align with the rule that returns or losses on their investment will be exact as the average market return or return of other participants.
- An acceptable and universal analysis system of pricing stocks should be adopted.
- The decision-making process of the market should be empty of human emotions that can lead to avoidable errors.
- Access to advanced systems or methods of pricing analysis.