The efficient market hypothesis (EMH) was promoted
by Eugene Fama in the 1960. In his classic paper Fama (1970) defined market in which prices
always fully reflect available information as “efficient”. While this definition reflects the main idea of the
EMH it might be extended to explain the underlying assumption. For example Malkiel (1992) proposed the following definition:
A capital market is said to be efficient to if it
fully and correctly reflects all relevant information in determining security prices. Therefore, more formally, the market
is efficient with respect to some information set. ..if security prices would
be unaffected by revealing that information to all participants. Moreover, efficiency implies that it is impossible to make
economic profits by trading on the basis of the defined information set (Papers4you.com, 2006).
As it follows from the Malkiel (1992) definition
if the market is efficient the company market value should be an unbiased estimate of the true value. Nevertheless it is important
to stress that:
Market efficiency does not require that market price is equal to the true value
There is an equal probability that stocks over or under valued at any point in the time
And finally, investors should not be able to consistently identify under or over valued stocks using any investment
strategy ( Damodaran, 2006).
What are the implications of the market efficiency
from the individual investor perspective?
Firstly, equity research is costly and provides
no benefits. Secondly strategies that have minimal execution costs such as randomly diversified portfolio or indexing to the
market would be superior to any other investment strategy. Thirdly, a strategy that has minimum transaction costs should provide
higher returns in the long run (Damodaran, 2006).
Nevertheless it is important to stress that markets
are not efficient due to their nature, but they are driven to efficiency by the actions of the investors. Therefore Roberts(1967)
distinguished among three forms of the market efficiency:
Weak form: the information set includes only historic data.
Semi strong: the information set includes publicly available information.
Strong form: the information set includes all information know to any market participant and includes private information.
Obviously in reality, investors have access to different
information sets. While trading which is based on the insider information is prosecuted, analysis and interpretation of the
publicly available information requires specific knowledge and skills (Papers4you.com, 2006). Therefore the efficient market
should be seen as a self correcting mechanism, where inefficiencies appear at regular intervals but disappear almost instantaneously
as investors find and trade on them.
wide applications in the financial markets, since it is easily extended to the valuation of companies , market failures such as an Enron Case, or performance analysis of the mutual funds. The traditional analysis of the market efficiency is based on the analysis of the anomalies such as Peso Effect in the foreign exchange market or devoted
to the predictability of the stock returns.
Damodaran )nline (2006) “MARKET EFFICIENCY
- DEFINITION AND TESTS”, Available from: http://pages.stern.nyu.edu/~ADAMODAR/ New_Home_Page/invemgmt/effdefn.htm [17/06/2006]
Fama E. F., 1970, Efficient capitalmarkets: Areviewof
theory and empiricalwork, Journal of Finance, 25, 383–417.
Malkiel B (1992) Efficient market hypothesis. In
NewMan P.M. Milgate ,and J Eawells (eds). The new Palgrave dictionary of Money and Finance.
Papers For You (2006) "C/F/94. Validity of the Efficient
Market Hypothesis", Available from http://www.coursework4you.co.uk/sprtfina2.htm [17/06/2006]
Papers For You (2006) "E/F/38. Efficient market
hypothesis: theory and implications", Available from http://www.coursework4you.co.uk/sprtfina2.htm [18/06/2006]
Robersts, H. 1967. Statistical versus clinical predictions
of the stock markets. Unpublished manuscript, Center for research in Security Prices, University of Chicago, May.