1
$\begingroup$

The Efficient Market Hypothesis tells us that stocks are "fairly priced" (i.e. not systematically over- or under-valued). That is, stock prices reflect all information that is already known about them. This is because any information from current or past events are already "absorbed" by the market. What is this "asborption" of information by the market supposed to mean? The market is comprised of its participants, buyers and sellers. I would also like to ask if the Efficient Market Hypothesis is built upon the following premises:

  1. All market participants have perfect information at all times, i.e. they know the operations of the companies listed on the stock exchange fully well and that they are also well-equipped with the financial knowledge required to interpret any economic news that may affect the performance of the listed companies.

  2. All market participants respond rationally and make decisions using the marginalist principle.

  3. Market participants are able to assess the circumstances readily at any one time and are able to respond to any new economic information (e.g. government macroeconomic policy changes, changes to corporate earnings etc.) instantly.

I just learnt about this concept and so I would just wish to seek clarification on it.

$\endgroup$
1
$\begingroup$

The efficient market hypothesis does not require everyone being omniscient. It works through the supply/demand and price mechanism.

For example, imagine that you have private information that a company X is doing bad (without being a manager or other person banned from insider trading). If company X is doing bad then sooner or later it’s stock price will have to go down, so if you own it’s stock you would sell it now while the price is still high or if you don’t own the stock you would short sell it.

However, as you start selling the stock you are pushing the price down. Since it’s profitable for you to sell or short sell as long as the market price is above the actual value of the company, you would do that so much that the price would eventually be driven to the point where the price is exactly equal it’s value.

The central assumption of the efficient market hypothesis is the perfect market assumption. In a perfect market there are no transactions costs, information is costless, investors are rational. In the real world however, these assumptions do not completely hold and the market is not fully efficient.

This being said, there is evidence that despite these imperfections markets are efficient to a certain extent as prices do adjust in response to new information. In fact it’s astonishingly hard to beat the market, and difficult to find deviations from the efficient market hypothesis empirically but now we know they exist.

| improve this answer | |
$\endgroup$
  • $\begingroup$ Isn't your example of someone having private information of company X a counterexample to the hypothesis? In your example, the private individual who has private information of a particular company has made significant profits by either selling the stock while its price is high or "short-selling" as he knows the price would fall (as news of the bad performance of the company would soon be widespread). $\endgroup$ – Tan Yong Boon Mar 19 at 10:13
  • $\begingroup$ I understand what you mean when it is said that forces of demand and supply and subsequently prices of stocks would adjust in the presence of new information about the economy (govt, firms, consumers). And that markets are efficient in that they adjust quickly and readily to these pieces of information. But what I don't understand is, why does this imply that one cannot "beat the market"? $\endgroup$ – Tan Yong Boon Mar 19 at 10:25
  • $\begingroup$ @TanYongBoon beat the market means that you can consistently deliver abnormal returns from trading (abnormal usually defined as returns above what you would expect or also often as returns above the index average). This however does not mean that by chance you might not get higher returns in some years. If efficient market hypothesis is true then you can’t do that because any new public information gets immediately priced and any private in formation is made public via the price system (that was the thing I tried to illustrate). So unless you have consistently access to private information $\endgroup$ – 1muflon1 Mar 19 at 10:48
  • $\begingroup$ You cannot outperform the market (just passively tracking the fund). This is also supported by empirical evidence which shows that except for few talented traders who can significantly consistently outperform the market most fail and also why usually good advice is not to have actively managed portfolio. However, since there are exceptions that implies that efficient market hypothesis does not strictly hold (although there are weaker versions of it). $\endgroup$ – 1muflon1 Mar 19 at 10:51
  • 1
    $\begingroup$ Hi: Yes, the ones with the firsthand information can profit but that doesn't disqualify the notion of market efficiency because the efficient markets hypothesis assumes that information is public and not known earlier for a few people. ( that would kind of be like insider trading ). Also, note that, as 1muflon1 pointed out, there are two ( or maybe even three. I forget ) different versions of market efficiency that differ in their assumptions about the market. But the concepts are the same. I think that one is called the strong form and the other the weak form $\endgroup$ – mark leeds Mar 20 at 13:06

Your Answer

By clicking “Post Your Answer”, you agree to our terms of service, privacy policy and cookie policy

Not the answer you're looking for? Browse other questions tagged or ask your own question.