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Efficient Market Hypothesis

Definition

The efficient-market hypothesis is a theory in financial economics that states that asset prices fully reflect all available information. A direct implication is that it is impossible to "beat the market" consistently on a risk-adjusted basis since market prices should only react to new information.

The Efficient Market Hypothesis (EMH) states that it is not easy to beat the market because the stock market efficiency reflects all the information. It further talks about stocks and how they always trade at fair value, which makes it hard for investors to sell them at a higher price. This is the main reason why it is not possible for an individual to outperform the market with the help of just stock selection.

In order to get higher returns, the only way out is to make investments that are deemed to be risky.

Discussing the Efficient Market Hypothesis (EMH)

The Efficient Market Hypothesis (EMH) is a controversial financial theory, which is why there are a lot of disputes between experts. Some state that there is no use of looking at undervalued stocks or predict the changing trends in the market by using technical analysis.

On the other hand, there are people who say that there is evidence that supports the theory. In order to understand the complexity of the theory, take the example of Warren Buffet who has actually beaten the market, which is something that is not possible according to the theory.

Limitations of the Theory

There are several limitations to the Efficient Market Hypothesis (EMH). Firstly, the empirical evidence is a little mixed up, but the data that is present does not strongly support the theory. Secondly, there is an anomaly that is presented to us in the form of speculative economic bubbles that states the market is operated by buyers who don’t take into account the underlying value. The anomalies that are presented are basically a result of the cost benefit analysis that is done by people who want to acquire information so they can trade on it.

The theory was scrutinized after the financial crises that persisted from 2007 to 2012. The EMH met with fierce criticism and it is said that the theory makes financial leaders underestimate the dangers of asset bubbles breaking.


Further Reading


Efficient market hypothesis
link.springer.com [PDF]
… Investment performance of common stocks in relation to their price earnings ratios: a test of the efficient markets hypothesis. Journal of Finance 32(3), June, 663-82 … Spectral analysis of New York Stock Market prices … On the impossibility of informationally efficient markets …

Efficient market hypothesis in European stock marketsEfficient market hypothesis in European stock markets
www.tandfonline.com [PDF]
… Investment performance of common stocks in relation to their price earnings ratios: a test of the efficient markets hypothesis. Journal of Finance 32(3), June, 663-82 … Spectral analysis of New York Stock Market prices … On the impossibility of informationally efficient markets …

The efficient market hypothesis and its criticsThe efficient market hypothesis and its critics
www.aeaweb.org [PDF]
… Investment performance of common stocks in relation to their price earnings ratios: a test of the efficient markets hypothesis. Journal of Finance 32(3), June, 663-82 … Spectral analysis of New York Stock Market prices … On the impossibility of informationally efficient markets …

The global financial crisis and the efficient market hypothesis: what have we learned?The global financial crisis and the efficient market hypothesis: what have we learned?
onlinelibrary.wiley.com [PDF]
… Investment performance of common stocks in relation to their price earnings ratios: a test of the efficient markets hypothesis. Journal of Finance 32(3), June, 663-82 … Spectral analysis of New York Stock Market prices … On the impossibility of informationally efficient markets …

Efficient market hypothesis and forecastingEfficient market hypothesis and forecasting
www.sciencedirect.com [PDF]
… Investment performance of common stocks in relation to their price earnings ratios: a test of the efficient markets hypothesis. Journal of Finance 32(3), June, 663-82 … Spectral analysis of New York Stock Market prices … On the impossibility of informationally efficient markets …

Efficient market hypothesis: evidence from a small open-economyEfficient market hypothesis: evidence from a small open-economy
www.tandfonline.com [PDF]
… Investment performance of common stocks in relation to their price earnings ratios: a test of the efficient markets hypothesis. Journal of Finance 32(3), June, 663-82 … Spectral analysis of New York Stock Market prices … On the impossibility of informationally efficient markets …

Efficient market hypothesis (EMH): past, present and futureEfficient market hypothesis (EMH): past, present and future
www.worldscientific.com [PDF]
… Investment performance of common stocks in relation to their price earnings ratios: a test of the efficient markets hypothesis. Journal of Finance 32(3), June, 663-82 … Spectral analysis of New York Stock Market prices … On the impossibility of informationally efficient markets …

On the emergent properties of artificial stock markets: the efficient market hypothesis and the rational expectations hypothesisOn the emergent properties of artificial stock markets: the efficient market hypothesis and the rational expectations hypothesis
www.sciencedirect.com [PDF]
… Investment performance of common stocks in relation to their price earnings ratios: a test of the efficient markets hypothesis. Journal of Finance 32(3), June, 663-82 … Spectral analysis of New York Stock Market prices … On the impossibility of informationally efficient markets …



Q&A About Efficient Market Hypothesis


Are there any other criticisms or limitations of EMH besides those mentioned above?

Yes, another limitation of EMH includes its inability to explain how some companies like Berkshire Hathaway have been able answer their critics over time while others like Enron were unable to do so despite having better fundamentals than Berkshire Hathaway when they started out."'

How can you get higher returns if you cannot beat the market?

You can make investments that are deemed risky.

What does it mean for stocks to always trade at fair value?

It means that stocks always trade at fair value, which makes it hard for investors to sell them at a higher price.

What is the Efficient Market Hypothesis?

The Efficient Market Hypothesis states that it is not easy to beat the market because the stock market efficiency reflects all the information.

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