THE EFFICIENT MARKET HYPOTHESIS AND THE RANDOM WALK THEORY
Simply stated, the Efficient Market Hypothesis (EMH) theorizes that at any given time, securities prices fully reflect all available information. However, the implications behind this hypothesis are truly profound, and continue to be the subject of intense debate between both academics and market professionals.
From the simplest market to the most sophisticated, individuals buy and sell securities based on their assumptions as to what the prices of those securities will do in the future. Simply put therefore, buyers will purchase at lower prices in anticipation of prices moving higher, while sellers will sell at higher prices in expectation of prices moving lower – this is true even for hedgers who are looking to offset price risks as opposed to maximise profits.
But under the Efficient Market Hypothesis, profits derived from the market will be the result of luck as opposed to skills, since current prices will be an accurate reflection of all information available to the market. Therefore, subsequent price movements will be the result of information no-one within the market will be able to anticipate until it has already happened.
The hypothesis itself was developed because of work done by the US economist Eugene Fama. In the 1960’s, Fama proposed that within any active market environment which is comprised of many well-informed, rational investors, no type of analysis can be performed which will enable any individual or individuals to outperform an appropriate benchmark (such as the S&P 500 for the US stock market). This type of market is therefore defined as efficient.
However, empirical research into the validity of the Efficient Market Hypothesis lead to the following 3 forms of EMH. Click each term to discover more.
| THE WEAK | The “Weak” form asserts that all past market prices and data are fully reflected in securities prices. In other words, technical analysis is of no use |
| SEMI-STRONG | The “Semi strong” form asserts that all publicly available information is fully reflected in securities prices. In other words, fundamental analysis is of no use. |
| STRONG | The “Strong” form asserts that all information is fully reflected in securities prices. In other words, even insider information is of no use. |
With most if not all securities markets full of well-informed professional traders, its perhaps shouldn’t be too surprising to discover the extent of academic research which supports the Efficient Market Hypothesis. Most early research was conducted to assess the viability of traditional technical analysis methods, with most discovering that traditional technical analysis-based strategies and systems provided little advantage to investors seeking a trading edge, aside from a few anomalies whose profits would be eliminated by the actual transaction costs of execution anyway.
On the other hand, there is also a large body of evidence that contradicts the Efficient Market Hypothesis! Although limited in both scope and duration due to the speed with which information is disseminated in most markets, market inefficiencies do exist and will almost certainly continue to exist as markets become more and more complex. The weight of evidence of both sides of the arguments means the Efficient Market Hypothesis brings up the paradox that the very assumption of market efficiency would generate inefficiency since no investor would then bother to analyse securities prices! Therefore, markets remain efficient by the very existence of certain participants who are actively seeking to profit from and exploit market inefficiencies.
Realistically, the truth is that no market is completely efficient or inefficient, but is a certain combination of both. While the markets for government bonds or large capitalization stocks have traditionally been considered as very efficient, real estate and venture capital markets are relatively inefficient due to often large discrepancies between the quantity and quality of information possessed by potential investors.
So, while the actual validity of the Efficient Market Hypothesis may be subject to significant argument, what isn’t open to debate is its relevance to the continuing debate between investors who advocate a passive approach and those who argue for a more active one. This debate is especially important considering that contrary to popular belief, most investors (even professional ones) consistently underperform industry benchmarks such as the S&P 500 or Dow Jones Industrial Index. This is mainly since the presence of transactions costs means that trading is less than a zero-sum game, with costs obviously related to the level at which participants actively interact with the markets.