Efficient Markets Hypothesis

The theory that where assets are traded in organized markets, prices take account of all available information, making it impossible to predict future price movements.

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

  1. 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.

  2. 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.

  3. 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

  1. “A Random Walk Down Wall Street” by Burton G. Malkiel
  2. “Efficient Market Hypothesis: Rationale, Evidence, and Implications” by Stephen F. LeRoy
  3. “Irrational Exuberance” by Robert J. Shiller
  • 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.
Wednesday, July 31, 2024