Efficient Market Hypothesis – Overview
EMH Overview
Today we briefly visit and discuss a favourite topic of investment exams – the efficient market hypothesis. We relate it to the main forms of investment analysis and provide arguments both in favour of and against the theory. We shall concentrate our discussion on the equity markets although the theory can apply to other assets.
Studies have shown that to a close approximation, share prices seem to follow a random walk with no discernible predictable patterns that investors can exploit. Such findings are now taken to be evidence of market efficiency, i.e. proof that market prices reflect all currently available information. Only new information will move stock prices, and this information is equally likely to be good or bad news.
Market participants distinguish among three forms of the efficient market hypothesis. The weak form claims that all information to be derived from past trading data is already reflected in share prices. The semi-strong form asserts that all publicly available information is already reflected. The strong form, which is generally acknowledged to be extreme, advises that all information, including insider information, is reflected in prices.
Technical analysis focuses on stock price patterns and on proxies for buy or sell pressure in the market. Fundamental analysis concentrates on the elements of the underlying value of the firm, such as current profitability and growth prospects. As both forms of analysis are based on public information, neither should generate excess profits if markets are operating efficiently.
Supporters of the efficient market hypothesis often advocate passive as opposed to active investment strategies. The policy of passive investors is to buy and hold a broad-based market index. They expend resources neither on market research nor on frequent purchase and sale of stocks and shares. Passive strategies can still be adjusted to meet individual investor requirements.
Empirical studies of technical analysis do not generally support the theory that such analysis can generate superior trading profits. One notable exception to this conclusion is the apparent success of momentum-based strategies over medium term periods.
A number of anomalies against the EMH have been uncovered. Amongst the many are the P/E effect, the small firm in January effect, the neglected company effect, post earnings announcement price drift, and book to market effect. Whether these anomalies represent an inefficient market or poorly understood risk premiums, is a matter for debate.
In the main, performance records of professionally managed funds lend little support to claims that most professional managers can beat the market.