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What is the Efficient Markets Hypothesis?

Short answer

An efficient market is one where it is impossible to beat the market because all information about securities is already reflected in their prices.

Example

Or rather a counter-example, ''I d be a bum in the street with a tin cup if the markets were efficient,'' Warren Buffett.

Long answer

The concept of market efficiency was proposed by Eugene Fama in the 1960s. Prior to that it had been assumed that excess returns could be made by careful choice of investments. Here and in the following the references to 'excess returns' refers to profit above the risk-free rate not explained by a risk premium, i.e. the reward for taking risk. Fama argued that since there are so many active, well-informed and intelligent market participants securities will be priced to reflect all available information. Thus was born the idea of the efficient market, one where it is impossible to beat the market.

There are three classical forms of the Efficient Markets Hypothesis (EMH). These are weak form, semi-strong form and strong form.

Weak-form efficiency: In weak-form efficiency excess returns cannot be made by using investment strategies based on historical prices or other historical financial data. If this form of efficiency is true then it will not be possible to make excess returns by using methods such as technical analysis. A trading strategy incorporating historical data, such as price and volume information, will not systematically outperform a buy-and-hold strategy. It is often said that current prices accurately incorporate all historical information, and that current prices are the best estimate of the value of the investment. Prices will respond to news, but if this news is random then price changes will also be random. Technical analysis will not be profitable.

Semi-strong form efficiency: In the semi-strong form of the EMH a trading strategy incorporating current publicly available fundamental information (such as financial statements) and historical price information will not systematically outperform a buy-and-hold strategy. Share prices adjust instantaneously to publicly available new information, and no excess returns can be earned by using that information. Fundamental analysis will not be profitable.

Strong-form efficiency: In strong-form efficiency share prices reflect all information, public and private, fundamental and historical, and no one can earn excess returns. Inside information will not be profitable.

Of course, tests of the EMH should always allow for transaction costs associated with trading and the internal efficiency of trade execution.

A weaker cousin of EMH is the Adaptive Market Hypothesis of Andrew Lo. This idea is related to behavioural finance and proposes that market participants adapt to changing markets, information, models, etc., in such a way as to lead to market efficiency but in the meantime there may well be exploitable opportunities for excess returns. This is commonly seen when new contracts, exotic derivatives, are first created leading to a short period of excess profit before the knowledge diffuses and profit margins shrink. The same is true of previously neglected sources of convexity and therefore value. A profitable strategy can exist for a while but perhaps others find out about it, or because of the exploitation of the profit opportunity, either way that efficiency disappears.

The Grossman-Stiglitz paradox says that if a market were efficient, reflecting all available information, then there would be no incentive to acquire the information on which prices are based. Essentially the job has been done for everyone. This is seen when one calibrates a model to market prices of derivatives, without ever studying the statistics of the underlying process.

The validity of the EMH, whichever form, is of great importance because it determines whether anyone can outperform the market, or whether successful investing is all about luck. EMH does not require investors to behave rationally, only that in response to news or data there will be a sufficiently large random reaction that an excess profit cannot be made. Market bubbles, for example, do not invalidate EMH provided they cannot be exploited.

There have been many studies of the EMH, and the validity of its different forms. Many early studies concluded in favour of the weak form. Bond markets and large-capitalization stocks are thought to be highly efficient, smaller stocks less so. Because of different quality of information among investors and because of an emotional component, real estate is thought of as being quite inefficient.

References and Further Reading

Fama, EF 1965 Random Walks in Stock Market Prices. Financial Analysts Journal September/October

Lo, A 2004 The Adaptive Markets Hypothesis: market efficiency from an evolutionary perspective. Journal of Portfolio Management 30 15-29

 
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