Market Efficiency

Behavior of an Efficient Market

The efficient-market hypothesis (EMH) asserts that financial markets are informationally efficient and should, therefore, move unpredictably. In finance, the efficient-market hypothesis (EMH) asserts that financial markets are "informationally efficient." As a result, given the information available when the investment is made, one cannot consistently achieve returns over average market returns on a risk-adjusted basis.

There are three major versions of the hypothesis: "weak," "semi-strong," and "strong." The weak-form EMH claims that prices on traded assets (e.g., stocks, bonds, or property) already reflect all past publicly available information. The semi-strong-form EMH claims that prices reflect all publicly available information and that prices instantly change to reflect new public information.

The strong-form EMH also claims that prices instantly reflect even hidden or "insider" information. Critics have blamed the belief in rational markets for much of the late 2000s financial crisis. In response, proponents of the hypothesis have stated that market efficiency does not mean having no uncertainty about the future. Market efficiency is a simplification of the world, which may not always hold true. The market is practically efficient for most individuals' investment purposes.

Random-Walk Model

Historically, there was a very close link between EMH and the random-walk model and then the Martingale model. The random character of stock market prices was first modeled by Jules Regnault, a French broker, in 1863 and then by Louis Bachelier, a French mathematician, in his 1900 PhD thesis, "The Theory of Speculation."

His work was largely ignored until the 1950s; however, beginning in the 1930s, scattered, independent work corroborated his thesis. A few studies indicated that U.S. stock prices and related financial series followed a random walk model. Research by Alfred Cowles in the 1930s and 1940s suggested that professional investors were, in general, unable to outperform the market.

Random Walk Stock market cannot be predicted.

Weak, Semi-Strong, and Strong

The efficient market hypothesis emerged as a prominent theory in the mid-1960s. Paul Samuelson had begun to circulate Bachelier's work among economists. In 1964, Bachelier's dissertation, along with the empirical studies mentioned above, was published in an anthology edited by Paul Cootner.

In 1965, Eugene Fama published his dissertation arguing for the random walk hypothesis, and Samuelson published proof of a version of the efficient market hypothesis. In 1970, Fama published a review of both the theory and the evidence for the hypothesis. The paper extended and refined the theory and included the definitions for three forms of financial market efficiency: weak, semi-strong, and strong.

It has been argued that the stock market is "micro efficient" but not "macro inefficient." Samuelson, the main proponent of this view, asserted that the EMH is much better suited for individual stocks than it is for the aggregate stock market. Research-based on regression and scatter diagrams has strongly supported Samuelson's dictum.

Source: Boundless Finance, https://ftp.worldpossible.org/endless/eos-rachel/RACHEL/RACHEL/modules/en-boundless-static/www.boundless.com/finance/textbooks/boundless-finance-textbook/security-market-efficiency-and-returns-9/market-efficiency-85/index.html
This work is licensed under a Creative Commons Attribution-ShareAlike 4.0 License.