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:

1.         Market efficiency does not require that market price is equal to the true value

2.         There is an equal probability that stocks over or under valued at any point in the time

3.         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:

1.         Weak form: the information set includes only historic data.

2.         Semi strong: the information set includes publicly available information.

3.         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. 

 

EMH  has 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.

 

References

 

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.