The efficient market hypothesis is a very important theory in finance. This article attempts to explain about efficient market hypothesis, its different forms along with the paradox and implications.
What is Efficient Market Hypothesis?
The efficient market hypothesis postulates that security (stock as well as debt) price reflects all available information. Hence, no one market participant can gain abnormal benefits from the trading of that security. In other words, any set of market information does not help market participants to earn abnormal benefits. In this situation, market participants cannot identify the under-valued and over-valued stock. This situation results from very quick adjustment of information so that nobody can beat the market.
When a market is perfectly efficient, following things should happen:
- Any information is universally available to all investors presumably at minimal cost.
- Current security price reflects all available relevant information.
- Only when new information became available, security price changes.
What are the different forms of efficient market hypothesis?
After the pioneer research by Eugene Fama (1965), the capital market efficiency came into play. It is Fama to formalize the proposition as ‘efficient market hypothesis’ and is widely accepted as the ‘information processing efficiency’.
Based on the information processing speed, there are three forms of efficient market hypothesis – weak, semi-strong and strong form. This differences occur from the notion of what is meant by the term “all available information”. There are three serially higher ordered sets of available relevant information. They are past prices, publicly available information, all publicly and privately available (insider, confidential, or privileged) information. And, these sets of information categorize the different forms of efficient market hypothesis.
Weak Form of Efficient Market Hypothesis
The weak form of hypothesis asserts that current security prices reflect all previous prices i.e. past prices. Equivalently, current price of a stock is solely determined by the technical analysis of the past prices. Technical analysts, also chartists, observe the past price movements and cyclical trends to repeat themselves, but can never beat the market provided that the market is efficient in weak-form. Chartists fail to beat the market because the information processing is so fast that all investors quickly know the significant movement in current security prices relative to past prices.
Put another way, technical analysis of past prices of a security cannot help predict the current price of that security. The adjustment in the current price is virtually instantaneous according to the previous prices. Hence, the technical analysis of previous prices cannot help investors to gain the abnormal benefits.
Semi-Strong Form of Efficient Market Hypothesis
The semi-strong form states that it is not only the past prices of securities that determine current prices, but also the publicly available information. Publicly available information includes firm’s data on its product line, balance sheet, income statement, earning forecast, patent held, quality of management, etc. In semi-strong form, current prices of securities incorporate the past prices as well as publicly available information. It is wherein the fundamental analysis comes to play role. The fundamentalist studies the firm and its business on the basis of past prices, current performance, and future prospects relative to the external environmental factors.
However, if the market is efficient in the semi-strong form, fundamental analysis of the publicly available information will be of valueless in gaining the abnormal benefits. Yet, there is room for fundamentalist to out-guess technical analyst, given the market is efficient in weak form only.
Strong Form of Efficient Market Hypothesis
This form of hypothesis contends that security price fully reflects all information including past prices, publicly, and privately available information. Here, privately available information refers to information available only to company insider i.e. confidential or privileged information. No one investor can get higher benefits than by holding a randomly selected portfolio of individual securities because no one investor has monopolistic access to the confidential information. In other terms, strong form of hypothesis claims that all market participants equally know even the insider information.
In the strong-form of efficiency, security price should reflect its intrinsic value based on the future expected returns and the degree of risk.
Not all these forms of hypotheses are independent to each other, but they are dependent and serially higher ordered in degree of efficiency. The semi-strong market efficiency encompasses the weak form of the market efficiency, because the sequence of the previous prices is a one form of the public information. Likewise, for the market to be efficient in the strong form it must also be efficient in the weak and semi-strong form, otherwise the stock price does not reflect all the available relevant information.
Note the figure above reveling the same ideologies, in which sets of information are subset of next successive higher ordered sets, but not the independent sets in themselves.
However, investors not always act rationally, they sometimes speculate. Neither the market is perfectly efficient nor the information is freely available (or presumably at low cost). Barrier to trade do exist and everyone cannot borrow and lend the fund at the same rate of interest. To sum up, frictions do exist in the market to make it imperfect.
That is why, the regulatory body prevents insiders from profiting by limiting on trading of the securities. Because, the corporate officers have access to insider information long before they are made public, thereby enabling them to profit. The entire insiders, their relatives, and any associates who trade on information supplied by insiders are considered in violation of the law, and this situation pertains especially in an inefficient market.
Paradox of Efficient Market Hypothesis
The paradox underlying the efficient market hypothesis is that the market should be inefficient for it to be efficient. Only if the investors disbelieve the efficiency of market, they try hard to gain the confidential and superior information in order to beat the market. If investors abandon these efforts, the efficiency of market will decrease substantially. This effort ultimately works as the fuel in keeping market efficient by manipulating the investment strategies.
In efficient market, price movement is random. The randomness of the stock prices requires that the transaction cost be zero, all available information to all investors be free, the market be large and liquid, investors have sufficient found to gain the advantage of the inefficiencies, all participants have the same time horizons and expectations about prices, all participants have the beliefs that he/she can outperform the market, etc. If all the aforementioned facts exist, then we can consider the hypothesis of efficient market.
What are the Economic Implications of Inefficient Market?
Lets present the following implications in light of inefficient market hypothesis:
Implication for Investors
Given the inefficient market, investors can develop profitable investment strategies if they do a proper analysis. That is to say, they could be better off by adopting a strategy that aims at outperforming the market rather than by adopting a “buy and hold” one. The technical help taken from the technical analyst seems to benefit the investors. This fact highlights the significant importance of the technical analyst and managers of the mutual funds in stock evaluation.
Implication for Portfolio Managers
Given the inefficient market, portfolio managers should engage in the active management approach, in which managers involve to find undervalued or overvalued stocks, to assets management rather than to follow the passive management approach, which aims only at establishing a well-diversified portfolio of securities without attempting to find undervalued or overvalued stocks.
Implication for Policy Makers
Given the inefficient market, efficient market hypothesis has an important implication for policy makers in understanding the allocation of the resources, formulating appropriate plans and policies. Deviations from efficiency may offer profit opportunities to better-informed traders at the expense of less-informed traders. The inefficient market has likelihood to increase unequal distribution of income. The misallocation of resources has the possibility of backtracking overall economic development process.
As the market inefficiency bears the cost of inefficient allocation of resources, it is not desirable and inhibits from the benefit of market economy. Therefore, it is relevant for the policy makers to seek the ways to enhance market efficiency by provisioning effective regulatory framework and its implementation so that the market be more reflective of a true picture of the economy.
In contrast to inefficient market, efficient market provides ready financing for worthwhile business venture and drains capital away from poorly managed or obsolete products producing corporations. It reduces the unequal distribution of the resources thereby reducing the income inequality. Efficient market seems to attract foreign investment, boosting domestic saving and improving the pricing and availability of capital.
If you want to know the calculation process of capital market index, NEPSE, then read this article.