8.19 Efficient Market Hypothesis

The efficient market hypothesis argues that all relevant information is already incorporated into the market price, and that stock prices move randomly and therefore unpredictably. Fundamental analysis is therefore pointless since no one can see the future. Most economists hold to this hypothesis in one form or another, and it is regularly taught to business studies students.

In its 'weak' form, the EMH claims that prices on traded assets already reflect all past publicly available information. In its 'semi-strong' form the hypothesis adds that prices instantly change to reflect new public information. In its 'strong' form, the EMH claims that prices instantly reflect hidden or 'insider' information. More exactly, in its 'strong' form the EMH asserts: {4}

1. Collective expectations of stock market investors are accurate predictions of the future prospects of companies.

2. Share prices fully reflect all information relevant to the prospects of traded companies.

3. Changes in share prices are entirely due to changes in information concerning future prospects, that information arriving in an unpredictable and random fashion.

4. Stock prices follow a Brownian movement or 'random walk, where past movements give no indication of what future movements will be.

The hypothesis was built on elegant economic models in the sixties, and gained support from studies that showed investment managers do not consistently beat the market, but is now being modified by behavioral market theories. {4}

Investor Objections

Investors argue that markets may be efficient some 85-90% of the time, but not always because: {1}

1. Some investors do consistently make money. Indeed, by simply holding stocks in the top ten Fortune 500 companies over the period 1976 to 2006, investors would have outperformed the S&P 500 index by some 4.85 times.

2. Investors can wildly overvalue stock during stock market bubbles, as they did in the 1997-2000 dot.com bubble. How did those stock prices incorporate relevant information and not market hype?

3. Stock prices fell immediately after 9/11. In what sense were mining companies, makers of cars and semiconductors, and service industries suddenly worth 5-15% less?

Theoretical Objections










The EMH was studied by many economists, but its original formulation owes much to W. F. Sharpe. {5} {6} The argument assumes rational behavior, markets in equilibrium and the reality of what economists call indifference or utility curves, a standard conception of neoclassical economics {7} where the vertical and horizontal axes of a graph represent amounts of two utilities (say 'Utility Y' and 'Utility X'). The curves link points where the consumer enjoys the same totals of utility (e.g. 10Ys and 1Xs, 6Ys and 2.2Xs, 2Ys and 5.4Xs, etc.) {8} Sharpe considered the tradeoff between return and risk (between, say, low-yielding but safe government bonds, and high-yielding but risky company stocks), modeling investors' preferences as indifference curves, the return being a 'good' utility and risk a 'bad' one. A budget line was introduced — the range of investments an investor could make (IOC: Investment Opportunity Curve) — and the investor was reasonably supposed to favor high returns with low risks.

The difficulty arose with moving from a single investor to the market as a whole, and Sharpe here assumed that 1. that investors all agreed on the expected prospects of each investment, and 2. that investors could borrow or lend as much as they liked at the same rate. Since the IOC was the same for all investors, a certain IOC portfolio would be preferred, and the demand lead to price adjustments, and so returns. The market would ensure a tradeoff between risk and return. As a refinement, Sharpe considered the relation of a share's return to the return of the market as a whole (the share's 'beta'). Others looked at how the firm was internally financed. But the unequivocal conclusion drawn from such modeling was that changes in share prices were entirely due to changes in information relevant to future prospects.

Or almost so. Unfortunately, the first assumption was that, once equilibrium had been reached, trade in that share would cease. That didn't seem to be the case. The second assumption was also unlikely: no one could purchase all the shares of a particular company because that degree of liquidity doesn't exist in reality. Sharpe was aware of these problems, accepting that investors are credit rationed, that the borrowing rate generally exceeds the lending rate, and that the borrowing rate generally increases with the amount borrowed — all problems that destroyed the model — but argued that ' the implications were not wildly inconsistent with observed behavior.' In short, the model was bogus, but the market behaved as the model said it should. {14}


Critics have blamed the EMH for much of recent financial troubles. Markets were self-correcting, it was argued — i.e. were not swayed by mass psychology, and so (despite asset bubbles and incentive-driven selling of complex derivatives) could be safely left to legislate themselves. {2} Post crash, these assumptions are taken less for granted. {12}

The EMH has collected a large literature. A review of the evidence by Malkiel (2003) concluded that markets were more efficient but less predictable than commonly believed. Efficient markets can make valuation errors, accept irrational behavior from investors, but do not allow investors to continually earn above-average returns without accepting above-average risks. Markets in the short run may be a voting mechanism, but act as a weighing mechanism in the long run: true value is disclosed eventually. Many stock market anomalies appear on analysis, but the transaction costs involved still argue against consistently profiting from such anomalies, though a buy and hold policy with 'value' stocks may still be possible. {11}

Efficiency and predictability are not necessary bedfellows, however. It is possible for markets to be efficient — or sufficiently so to prevent trading strategies being consistently profitable — but still be somewhat unpredictable. If investors watch other investors — i.e. the previous day's prices enter into their buy or sell calculations, for which there's good evidence { 17} {18} — then stock markets are not static systems tending to equilibrium, but time-dependent complex systems which will inevitably throw up bizarre results from time to time. As the standard deviation of daily movements on the Dow Jones Industrial Average is roughly 1%, but over 60 daily movements of 5% were recorded in the twentieth century, the odds against that happening show clearly that movement isn't random. {19} Moreover, since stock markets are complexly interlinked, bizarre movements can trigger worldwide disturbances, which is possibly an explanation for foreign currency crises sometimes laid at the door of hedge fund manipulation.

Attention has also shifted to intermediaries — fund managers, banks, fund managers, brokers and other specialists — who have better information than lay investors but may be driven more by commissions than service to clients. Market momentum distortions may also be increased by investors transferring from underperforming to overperforming fund managers. {13}

Manipulation of the stock market by large banks and government institutions is also a possibility, but not one taken seriously by the mainstream press. {21-22}

Finally, of course, absence of evidence is not proof of non-existence. No profitable trading strategy, should one exist, is likely to be publicly aired, i.e. confided to academic researchers or divulged on websites.

The EMH is important because impending regulation may be reduced to 'light touch' if governments can be persuaded that capital markets are indeed efficient and self correcting. The balance of disputed evidence to date, both empirical and theoretical, rather suggests they are not.

Points to Note

1. The Efficient Market Hypothesis and its critics.
2. Wide spread of current views, with no consensus in sight.
3. Importance of the arguments to market regulation.


1. What is the Efficient Market Hypothesis?
2. Briefly review the evidence for and against the EMH.
3. Why is the EMH important?

Sources and Further Reading

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