Background
The Efficient Markets Hypothesis (EMH) is a central theory in financial economics that posits asset prices fully reflect all available information. This theory implies that it is impossible to consistently achieve higher returns on investments through any form of market analysis or trading strategy because prices always incorporate and reflect information rapidly and accurately.
Historical Context
The EMH was popularized by Eugene Fama in the 1960s through his groundbreaking work on stock price behavior. The concept has roots in earlier work, such as that of Louis Bachelier in his 1900 dissertation, which described market prices as a “martingale” process. With time, EMH became highly influential, especially in the realms of stock market investment and financial theory.
Definitions and Concepts
Efficient Markets Hypothesis: The theory that asset prices in organized markets incorporate all available information, prohibiting the ability to predict whether certain assets will provide better risk-adjusted returns than others.
Three Forms of Market Efficiency
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Weak-form efficiency: Asserts that it is impossible to achieve excess returns using historical price data since the current prices already integrate past price information.
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Semi-strong efficiency: Proclaims that all public information is accounted for in asset prices, thus, no excess returns can be earned by trading based on this public information.
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Strong-form efficiency: Suggests that all information, both public and private, is fully incorporated in prices, hence making it impossible to achieve excess returns even through insider information.
Major Analytical Frameworks
Classical Economics
While not directly connected to EMH, Classical Economics’ emphasis on market rationality laid the groundwork for later theories like EMH.
Neoclassical Economics
EMH aligns closely with Neoclassical Economics, which assumes rational behavior by market participants and rapid information dissemination.
Keynesian Economics
Keynesians may critique EMH by pointing out instances of market irrationalities and behavioral biases that lead to market inefficiencies.
Marxian Economics
From a Marxian perspective, EMH would be contested on the grounds that it overlooks systemic and structural factors influencing market dynamics.
Institutional Economics
Institutionalists would argue that the features of institutions, including regulations and market structures, influence the efficiency of markets and thus, render EMH overly simplistic.
Behavioral Economics
Behavioral economists challenge the assumptions of EMH by demonstrating how psychological factors and cognitive biases lead to inefficient market behavior.
Post-Keynesian Economics
Post-Keynesians question the EMH by emphasizing that markets are often driven by speculative behavior rather than the rational assimilation of information.
Austrian Economics
Austrian economists, who consider knowledge and information as dispersed and subjective, might dispute EMH’s assumption of universally known and instantaneously reflected information.
Development Economics
In emerging markets, where information dissemination may be less efficient, the EMH may be harder to validate, leading to alternative approaches to understanding market efficiency in these contexts.
Monetarism
Monetarist perspectives might be more aligned with EMH, considering a rational approach to how money supply and other macroeconomic indicators are anticipated by markets.
Comparative Analysis
When comparing EMH across different analytical frameworks, it becomes evident that while some support it with caveats, others fundamentally challenge its assumptions. For example, Behavioral Economics and Keynesianism provide robust counterarguments highlighting the irrational and speculative side of human behavior which is often overlooked by EMH.
Case Studies
Case Study 1: Dot-com Bubble
During the late 1990s, the rapid increase and subsequent crash of internet-related company stock prices showed that even markets believed to be efficient could experience substantial deviations from intrinsic values.
Case Study 2: Housing Market Crisis (2007-2008)
The housing market collapse illustrated how misinformation and irrational market exuberance could lead to significant discrepancies between market prices and underlying economic value.
Suggested Books for Further Studies
- “A Random Walk Down Wall Street” by Burton G. Malkiel
- “Efficient Market Hypothesis: Rationale, Evidence, and Implications” by Stephen F. LeRoy
- “Irrational Exuberance” by Robert J. Shiller
Related Terms with Definitions
- Rational Expectations Theory: The hypothesis that individuals form forecasts about future events using all available information in an unbiased and consistent manner.
- Market Anomalies: Instances where actual market outcomes deviate from predictions made by the Efficient Markets Hypothesis.
- Arbitrage: The simultaneous purchase and sale of an asset to profit from a difference in the price in different markets, which in a theoretically efficient market should not exist.