Efficient Market Hypothesis

Efficient Market Hypothesis Definition

The efficient market hypothesis (EMH) states that the stock prices indicate all relevant information and such information is shared universally which makes it impossible for the investor to earn above-average returns consistently. The assumptions of this theory are highly criticised by behavioural economists or by the others who believe in the inherent inefficiencies of the market. The idea of the efficient market hypothesis was given by an economist Eugene Fama in the 1960s.

Assumptions of EMH

  • The investors in the market act rationally or normally, which means if there is unusual information, the investor will react to it unusually, which is normal behaviour. Or do what everyone else is doing is also considered normal behaviour.
  • The stock price indicates all the relevant information and such information is shared universally among the investors.

Forms of Efficient Market Hypothesis

Efficient Market Hypothesis

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The strength of the assumptions of the efficient market hypothesis (EMH) theory is depended upon the forms of EMH. The following are the forms of EMH:

  • Weak Form: It states that the stock prices indicate the public market information and the past performance has nothing to do with the future prices.
  • Semi-Strong Form: It states that the stock prices reflect both the market and non-market public information.
  • Strong Form: It states that the stock prices are characterised by both the public and private information instantly.

Example of the Efficient Market Hypothesis

Suppose a person named Johnson holds 900 shares of an automobile company and the current price of these shares trade at $156.50. Johnson had some relations with an insider of the same company who informed Johnson that the company has failed in their new project and the price of a share will decline in the next few days.

Johnson had no faith in the insider, and he continues to hold all his shares. After a few days, the company announces the project’s failure, which results in the dropping of the share price to $106.00.

The market modifies to the newly available information. To realise the gross gain, Johnson sold his shares at $106.00 and realised a gross gain of $95,500. If Johnson had sold his 900 shares at $156.50 earlier by taking the insider’s advice, he would have earned $140,850. So, his loss for the sale of 900 shares is $140,850-$95,500 i.e. $45,350.

Criticism

Criticism of the Efficient Market Hypothesis

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  • Existence of Market Bubbles: One of the biggest reasons behind the criticism of EMH is market bubbles. So, if such assumptions were correct, there was no possibility of bubbles and crashing incidents such as stock market crash and housing bubbles in the 2008 or the tech bubble of the 1990s. Such companies were trading in high values before crashing.
  • Wins against the Market: Some investors won against the market consistently, such as Warren Buffett. He had earned above-average profit from the market consistently for over 50 years by his value investing strategy. Some behavioural economists also highly criticise the assumptions of the theory of efficient market hypothesis because they believe that past performances help to predict future prices.

Implication

The efficient market hypothesis implies that the market is unbeatable because the stock price already contains all the relevant information. It created a conflict in the mind of the investors. They started believing that they can’t beat the market as the market is not predictable, and future prices depend upon today’s news and not upon the trends or the company’s past performances. However, this theory was criticised by many economists.

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