Revision: Efficient Market Hypothesis

Topics: Stock market, Stock, Fundamental analysis Pages: 5 (1640 words) Published: January 23, 2014
Definition of 'Efficient Market Hypothesis - EMH'
An investment theory that states it is impossible to "beat the market" because stock market efficiency causes existing share prices to always incorporate and reflect all relevant information. According to the EMH, stocks always trade at their fair value on stock exchanges, making it impossible for investors to either purchase undervalued stocks or sell stocks for inflated prices. As such, it should be impossible to outperform the overall market through expert stock selection or market timing, and that the only way an investor can possibly obtain higher returns is by purchasing riskier investments. Explanation of 'Efficient Market Hypothesis - EMH'

Although it is a cornerstone of modern financial theory, the EMH is highly controversial and often disputed. Believers argue it is pointless to search for undervalued stocks or to try to predict trends in the market through either fundamental or technical analysis. Meanwhile, while academics point to a large body of evidence in support of EMH, an equal amount of dissension also exists. For example, investors, such as Warren Buffett have consistently beaten the market over long periods of time, which by definition is impossible according to the EMH. Detractors of the EMH also point to events, such as the 1987 stock market crash when the Dow Jones Industrial Average (DJIA) fell by over 20% in a single day, as evidence that stock prices can seriously deviate from their fair values.

Implications for corporate finance
1. Managers cannot fool the market through creative accounting. 2. Firms cannot successfully time issues of debt and equity. 3. Managers cannot profitably speculate in securities market. 4. Managers can reap benefits by paying attention to market prices.

Implications for investment management

1. If the market is efficient in weak-form, investors can not obtain abnormal returns by analyzing relevant historical information about the securities. However, it is possible to obtain abnormal returns by analyzing current information and future information. Thus, investment tools like filter strategy, technical analysis will not be effective. Fundamental analysis will be an effective approach for investment management. 2. If the market is efficient in semi-strong form, analysis of relevant historical and current information is of no use for gaining abnormal returns. Only access to future information will give abnormal returns. Thus, filter strategy, technical analysis, and fundamental analysis will not be effective for investment management. 3. If the market is efficient in strong-form, analysis of past, present, and future information is of no use to gain abnormal returns. Random selection of the stocks based on defined returns or risk will be the best approach for investment. Portfolio investment will be the only way to maximize returns for given level of risk or minimize risk for given level of returns.

Three Pillars of Efficient Market Hypothesis
The necessary conditions for market efficiency are:

1. Rationality:
All investors in the market should be rational. When relevant information is released in the market by a firm, all investors will adjust their estimates of stock prices of the firm in a rational way. E.g., the relevant information could be the announcement of new product development by a firm.

2. Independent deviations from rationality:
If the relevant information, say the announcement of new product development by a firm is not complete, some investors might get caught up in the romance of a new product development. The announcement by the firm may be incomplete in terms of projected sales, price, cost of the new product and the time it will take for other companies to develop a competing product. Irrational investors may project future sales well above what is rational. They would over pay for the stock and push the prices up. If these investors dominate the market, the stock prices are...
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