Efficient Market Hypothesis

American Economist Eugene Fama won the Nobel prize for economics for developing new methods to study trends in asset markets. He is one of the three American Economists who won Nobel Prize for Economic Sciences. He shared Nobel for Economic Sciences jointly with Robert Shiller and Lars Peter Hansen.

Eugene Francis “Gene” Fama is known for his work on portfolio theory and asset pricing. Fama is regarded as the father of the “Efficient Market Hypothesis”. In 1970 issue of the Journal of Finance, entitled “Efficient Capital Markets: A Review of Theory and Empirical Work,” Fama gave the concept of EMH (Efficient Market Hypothesis).

What is EMH (Efficient Market Hypothesis)?

It is a hypothesis, which says that no person can perform better than the Market itself without taking more risk than the market, because every information is built in the market itself. In simple words we can say: Financial markets are “informationally efficient” i.e. that price of an asset reflects all information about an asset. Thus, it is virtually impossible to regularly predict asset prices and “beat the market” i.e. generate returns that are higher than overall market on average without incurring more risk than the market.

As per this hypothesis, stocks on a stock exchange always trade at fair market value, thus it is impossible for any investor to purchase an undervalued stocks or sell a stock for inflated prices. The only means by which an investor can obtain higher returns is via purchasing taking more risk.

Reading the market is impossible because the stocks are already accurately priced and reflect all available information. Therefore it is impossible to make profit with any trading strategy. Theoretically impossible to make profit from any trading strategy. Thus, there is no way to identify a bargain stock or use past stock price movements to predict future prices. The only way to earn higher returns than those of an index is by purchasing higher risk investments.

So if Ramesh wants to buy a share of Infosys at Rs 3,000 per share he will not be able to make any profit because as per the EMH the intrinsic value of a share of Infosys is Rs 3,000 per share, so Ramesh will not be able to profit from a potential under-valued or over-priced share of Infosys.

3 forms of Efficiencies as per EMH (Efficient Market Hypothesis):-

1) Weak Form Efficiency

2) Semi-Strong Form Efficiency

3) Strong Form Efficiency

In weak-form efficiency, it is said that one can’t predict future prices by analyzing prices from past i.e. historical data. Thus, one cannot earn excess return for long time by his/her strategy based on historical share prices.

In semi-strong-form efficiency, it is said that a share’s price adjust itself to all publicly available new information, thus one cannot earn one cannot earn excess return for long time by his/her strategy based on publicly available information.

In strong-form efficiency, it is said that a share’s price reflects all information, public and private, and no one can earn excess returns for long time by his/her strategy based on all publicly available information and historical data.

What do the critics say about Efficient Market Hypothesis (EMH)?

EMH is highly controversial and often disputed.

There are several reasons why EMH may be incorrect:-

1. All investors come to know of information differently and will thus have different valuations of the stock.

2. Stocks take time to respond to new information, investors who receive or act on this information first can take advantage of it

3. Stock prices can be affected by human error and emotional decision making.

4. Investors like Warren Buffet have proven that they can profit from market consistently over long periods of time

5. If EMH is true, then investors should place all their assets in index funds and thus they will earn same returns as overall market and focus on minimizing their risk.