Market Efficiency Hypothesis Explained
The Market Efficiency Hypothesis proposes that market prices always truly reflect actual value, and so trying to predict future price movements is pointless.
In this article we’ll look at what market efficiency is, its different forms, how it affects trading strategies, and criticisms of the theory.
Defining market efficiency
Market efficiency is defined as the degree to which market prices reflect all available, relevant information. The term was first coined by economist Eugen Fama in his 1970 paper in which he proposed the Efficient Market Hypothesis (EMH). His theory puts forward the idea that share prices already take into account all existing information and are a reliable representation of the true value of markets, and their prices are always “fair”. It also states that it is impossible for traders to consistently outperform the market.
The degree to which the market is efficient is heavily debated within the financial realm, to the point that it functions almost like a belief system, with EMH believers stating that the market accounts for all information, and critics denying such faultlessness. Proponents of strong market efficiency have “faith” that the market is pure, and its prices are truly representative of value, and thus cannot be beaten. Disputants of EMH refute this idea. The idea of market efficiency is further broken down into three degrees:
-
Strong form market efficiency. This is EMH in its purest form, and posits that all information in a market, both public and private, is reflected in an asset’s price. Believers of strong form efficiency say that even insider information could not give investors an advantage. They believe that market prices perfectly represent the underlying assets’ value.
-
Semi-strong form efficiency. Widely considered to be the most practical form of EMH, it assumes that all public information, but not private information, is factored into the current prices in the market. The semi-strong market efficiency theory states that fundamental and technical analysis cannot be used to achieve significant gains.
-
Weak form market efficiency: The idea behind this form states that past price movements, volume, and earnings data have no impact on market prices, and cannot be used to make accurate predictions about its future price movements. Advocates of this form see technical analysis and financial advisors as fundamentally useless.
According to the Efficient Market Hypothesis, a market’s efficiency is determined by how well prices reflect all information that is available. So, if markets are efficient, then all information is reflected in prices, making it impossible for a trader to “beat” the market as securities could not possibly be undervalued.
Support for market efficiency
EMH is a highly controversial theory, with experts both supporting and criticizing it. In 2009, Morningstar Inc. conducted a ten-year study on active managers’ returns in all categories, which they compared to a composite of index funds and ETFs. They found that only 23% of active fund managers performed successfully compared to managers who traded passively, which they cite as proof of EMH. Since only a quarter of asset managers could perform consistently well over time, the researchers attributed their success to luck.
In 1973, Princeton economics professor Burton G. Malkiel published a book called “A Random Walk Down Wall Street”. The main idea of the book was that earnings estimates, technical analysis, and investment advisory services are “useless”, and a “buy-and-hold” strategy is optimal. He stipulated that a blindfolded monkey should fare no worse than a so-called stock expert. His “Random Walk” theory is a key component of EMH, as it suggests that future price movements are impossible to predict and are basically random.
In contrast, the idea of an inefficient market suggests that publicly available information is not reflected in the market price, and so assets can be significantly under or overvalued. One example of an inefficient market in practice is the phenomenon of “earnings surprises” in the stock market. This occurs when a company's earnings announcement contains information that is not fully anticipated by the market, leading to a significant and unexpected price movement. This would bolster the idea of a semi-strong form market efficiency, as the price changes to reflect information which becomes publicly available.
Market efficiency criticism
As much as there is evidence to support the Efficient Market Hypothesis, many critics point to examples and arguments that disprove it. The theory’s validity has been brought into question on both theoretical and empirical grounds.
Warren Buffett is often referenced, as his trading strategy of focusing on undervalued stocks made him a billionaire and led to scores of investors following in his footsteps. If the market is efficient and prices accurately reflect value, then investors like Buffett could not continuously outperform the market. Proponents of EMH again explain away the performance of successful investors as based on “luck”.
Also referenced in criticisms of EMH is the 1987 stock market crash. The Dow Jones plummeted by over 20% in a completely unpredictable turn of market events. Asset bubbles also point to a lack of market efficiency.
Additionally, EMH does not take into account the role of behavioral finance, which suggests that investors may not always act rationally. The hypothesis would assume that an efficient market is made up only of rational participants, which is highly unrealistic, especially when you consider the sometimes-ill-informed behavior of private or retail investors.
Eugene Fama, although having developed EMH himself, later went on to acknowledge that markets may not be entirely efficient and proposed the Adaptive Market Hypothesis. This incorporated behavioral finance into his original theories.
Nobel laureates Robert Shiller and Richard Thaler are both prominent figures in the field of psychological and behavioral finance. Shiller emphasizes the impact of investor sentiment and emotions on market movements. Thaler’s research highlights the role of psychological biases in decision-making, and he challenges the assumption of rationality in market participants.
Joseph Stiglitz, a Nobel laureate and former chief economist of the World Bank, has been critical of the EMH. He argues that information asymmetry, imperfect competition, and behavioral biases contribute to market inefficiencies. Stiglitz's work emphasizes the importance of information imperfections in financial markets.
Implications and strategies for investors
The idea that market prices would always perfectly reflect their true value has serious implications on investment strategies. Essentially, it treats the market as infallible, making any attempts to beat it futile. It declares that future price movements are completely unpredictable as they already reflect all relevant information (including known future market events for example). This would essentially mean that all techniques for fundamental and technical analysis are pure speculation and not based on any scientific evidence.
Proponents of EMH offer alternative approaches that overcome market efficiency and lead to successful trading:
-
Passive Investing. Many investors adopt passive strategies, such as index fund investing, which aims to replicate the performance of a market index.
-
Diversification. EMH highlights the importance of diversification. Since all available information is reflected in prices, spreading investments across various assets allows traders to manage risk.
-
Long-Term Focus. Investors influenced by EMH often adopt a long-term investment horizon. Trying to time the market or make short-term predictions is seen as unreliable.
-
Risk Management. Investors should place greater emphasis on risk management strategies, acknowledging that markets are unpredictable, and unexpected events can impact asset prices.
Best stock brokers 2024
FAQs
How does market efficiency impact the performance of actively managed funds?
It implies that all relevant information is already reflected in prices. This makes it difficult for fund managers to consistently ‘beat’ the market, which brings into question the value and cost-effectiveness of active management.
Can market inefficiencies persist in the long term?
Market inefficiencies may persist in the long term due to various factors, including behavioral biases, information asymmetry, and slow market adaptation.
What role do regulatory changes play in altering market efficiency?
Regulatory changes can significantly impact market efficiency by altering information disclosure requirements, trading practices, and market structure. Effective regulations enhance transparency and fairness, contributing to a more efficient market.
How does the concept of market efficiency relate to the concept of market bubbles?
An efficient market makes it difficult to grapple with the reality of market bubbles as it questions the rationality of asset prices. In efficient markets, prices reflect all available information, but during bubbles, prices may deviate significantly, indicating an absence of market efficiency.
Glossary for novice traders
-
1
Broker
A broker is a legal entity or individual that performs as an intermediary when making trades in the financial markets. Private investors cannot trade without a broker, since only brokers can execute trades on the exchanges.
-
2
Market Efficiency
Market efficiency is defined as the degree to which market prices reflect all available, relevant information. The term was first coined by economist Eugen Fama in his 1970 paper in which he proposed the Efficient Market Hypothesis (EMH).
-
3
Trading
Trading involves the act of buying and selling financial assets like stocks, currencies, or commodities with the intention of profiting from market price fluctuations. Traders employ various strategies, analysis techniques, and risk management practices to make informed decisions and optimize their chances of success in the financial markets.
-
4
Investor
An investor is an individual, who invests money in an asset with the expectation that its value would appreciate in the future. The asset can be anything, including a bond, debenture, mutual fund, equity, gold, silver, exchange-traded funds (ETFs), and real-estate property.
-
5
Index
Index in trading is the measure of the performance of a group of stocks, which can include the assets and securities in it.
Team that worked on the article
Jason Law is a freelance writer and journalist and a Traders Union website contributor. While his main areas of expertise are currently finance and investing, he’s also a generalist writer covering news, current events, and travel.
Jason’s experience includes being an editor for South24 News and writing for the Vietnam Times newspaper. He is also an avid investor and an active stock and cryptocurrency trader with several years of experience.
Dr. BJ Johnson is a PhD in English Language and an editor with over 15 years of experience. He earned his degree in English Language in the U.S and the UK. In 2020, Dr. Johnson joined the Traders Union team. Since then, he has created over 100 exclusive articles and edited over 300 articles of other authors.
Mirjan Hipolito is a journalist and news editor at Traders Union. She is an expert crypto writer with five years of experience in the financial markets. Her specialties are daily market news, price predictions, and Initial Coin Offerings (ICO).