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Information > Financial Terms > This page Efficient Market Hypothesis The efficient
market hypothesis of movements of stock prices in its weak variant stands
for the proposition that successive stock prices are mostly unrelated
and that prices tend to move in a random manner. The randomness of stock prices is reported to be confirmed
by analysis of successive price changes, indicating low serial correlation
coefficients, and by simulated charting of random numbers, indicating
patterns of price movements similar to actual price movement patterns.
On this basis, proponents of the random walk hypothesis dismiss
the usefulness of TECHNICAL, ANALYSIS, an approach for predicting stock
prices based on the price patterns developed by prior price data. A second variant
of the efficient market hypothesis stands for the proposition that:
(1) there are many participants in an efficient market; (2) such
participants have access to all relevant information affecting stock prices;
and (3) such participants compete freely and equally for the stocks, causing,
because of such competition and the full information available to the
participants, full reflection of the worth of stocks in their prevailing
prices. As new information
randomly develops and is acted upon and reflected in prices, stock prices
in turn behave randomly. A third variant
of the efficient market hypothesis stands for the proposition that prevailing
stock prices fully reflect and discount not only publicly available information
but also private and expert analyses and information, such as that made
available to institutional investors in consideration of routing commission
business to particular brokerage firms, and "research boutiques."
Since performance of institutional investors such as investment
companies is found to be not much different from results of noninstitutional
portfolios and from randomly selected portfolios, it is concluded again
that prevailing stock prices in responding promptly to randomly developed
information, whether publicly or privately available through expert analyses,
behave randomly, and that professional money managers do not achieve consistently
superior performance because of superior access to superior information. All three variants
of the efficient market hypothesis challenge the validity of fundamentals
analysis and technical analysis, and in turn are challenged by adherents
of the fundamental and technical approaches. The efficient
markets theory, or what is also called "the new investment technology,"
is the idea that security markets are efficient and that investment rewards
are related to risk. According to this
theory, a market is said to be efficient if it functions in such a way
that transaction costs to buyers and sellers in the market are relatively
low and information on new developments is quickly disseminated to all
parties. Market prices will
reflect such new information. Advocates of the
efficient markets theory stress that risk has its rewards, and, on average,
investors obtain greater returns for incurring greater risks.
They emphasize that if investments are always efficiently priced
in the market, the only way for the average investor to obtain returns
above the average for the market is to take on more risk. Over the past
several decades, numerous academic studies have examined the question
of the relative efficiency of security markets. Most of these studies
have found that the money and capital markets are weak-form efficient,
and some have reported semistrong-form efficiency.
Markets dot not appear to be strong-form efficient, so possessors
of inside information have a definite advantage over the average investor. The efficient
markets theory suggests that even professional money managers, unless
they have access to inside information, cannot consistently obtain returns
above the average for the market as a whole unless they are willing to
take on an above average level of risk.
Some of the most convincing evidence in support of the theory has
been amassed by studies that show that the great majority of professional
investment managers do not consistently outperform the market averages. Indeed, Burton Malkiel, one of the foremost proponents of the
efficient markets theory, claims that "no scientific evidence has yet
been assembled to indicate that the investment performance of professionally
managed portfolios as a group has been any better than that of randomly
selected portfolios." BIBLIOGRAPHY GREEN, G.H.
"The Effect of Inter-Regional Efficiency on Appraising Single Family
Homes." The Real Estate
Appraiser and Analysts, Winter, 1988. IPPOLIYO, T.S.
"Efficiency With Costly Information:
A Study of Mutual Fund Performance, 1965-1984."
The Quarterly Journal of Economics, February, 1989. |