The efficient-market hypothesis (EMH) is a theory in financial economics that states

that asset prices fully reflect all available information. A direct implication is that it is impossible

to "beat the market" consistently on a risk-adjusted basis since market prices should only react to

new information.

The efficient-market hypothesis was developed by Eugene Fama who argued that stocks always

trade at their fair value, making it impossible for investors to either purchase undervalued stocks

or sell stocks for inflated prices. As such, it should be impossible to outperform the overall

market through expert stock selection or market timing, and that the only way an investor can

possibly obtain higher returns is by chance or by purchasing riskier investments. His 2012 study

with Kenneth French supported this view, showing that the distribution of abnormal returns of

US mutual funds is very similar to what would be expected if no fund managers had any skill—a

necessary condition for the EMH to hold.

There are three variants of the hypothesis: "weak", "semi-strong", and "strong" form. The weak

form of the EMH claims that trading information (levels and changes of prices and volumes) of

traded assets (e.g., stocks, bonds, or property) are already incorporated in prices. If weak form

efficiency holds then technical analysis cannot be used to generate superior returns. The semi-

strong form of the EMH claims both that prices incorporate all publicly available information

(which also includes information present in financial statements, other SEC filings etc.). If semi-

strong form efficiency holds then neither technical analysis nor fundamental analysis can be used

to generate superior returns. The strong form of the EMH additionally claims that prices

incorporate all public and non-public (insider) information, and therefore even insiders cannot

expect to earn superior returns (compared to the uninformed public) when they trade assets of

which they have inside information.

There is no quantitative measure of market efficiency and testing the idea is difficult. So-called

"effect studies" provide some of the best evidence, but they are open to other

interpretations.[3] Critics have blamed the belief in rational markets for much of the late-2000s

financial crisis.[4][5][6] In response, proponents of the hypothesis have stated that market

efficiency does not mean not having any uncertainty about the future; that market efficiency is a

simplification of the world which may not always hold true; and that the market is practically

efficient for investment purposes for most individuals.

Historical background[edit]

Benoit Mandelbrot claimed the efficient markets theory was first proposed by the French

mathematician Louis Bachelier in 1900 in his PhD thesis "The Theory of Speculation"

describing how prices of commodities and stocks varied in markets.[8] It has been speculated that

Bachelier drew ideas from the random walk model of Jules Regnault, but Bachelier did not cite

him,[9] and Bachelier's thesis is now considered pioneering in the field of financial

mathematics.[10][9] It is commonly thought that Bachelier's work gained little attention and was

forgotten for decades until it was rediscovered in the 1950s by Leonard Savage, and then become

more popular after Bachelier's thesis was translated into English in 1964. But the work was never

forgotten in the mathematical community, as Bachelier published a book in 1912 detailing his

ideas,[9] which was cited by mathematicians including Joseph L. Doob, William

Feller[9] and Andrey Kolmogorov.[11] The book continued to be cited, but then starting in the

1960s the original thesis by Bachelier began to be cited more than his book when economists

started citing Bachelier's work.[9]

The efficient markets theory was not popular until the 1960s when the advent of computers made

it possible to compare calculations and prices of hundreds of stocks more quickly and

effortlessly. In 1945, Hayek argued that markets were the most effective way of aggregating the

pieces of information dispersed among individuals within a society. Given the ability to profit

from private information, self-interested traders are motivated to acquire and act on their private

information. In doing so, traders contribute to more and more efficient market prices. In the

competitive limit, market prices reflect all available information and prices can only move in

response to news. Thus there is a very close link between EMH and the random walk

hypothesis.[12]

Empirically, a number of studies indicated that US stock prices and related financial series

followed a random walk model in the short-term.[13] Whilst there is some predictability over the

long-term, the extent to which this is due to rational time-varying risk premia as opposed to

behavioral reasons is a subject of debate. Research by Alfred Cowles in the 1930s and 1940s

suggested that professional investors were in general unable to outperform the market.

Impacts[edit]

The efficient-market hypothesis emerged as a prominent theory in the mid-1960s. Paul

Samuelson had begun to circulate Bachelier's work among economists. In 1964 Bachelier's

dissertation along with the empirical studies mentioned above were published in an anthology

edited by Paul Cootner.[14] In 1965, Eugene Fama published his dissertation arguing for the

random walk hypothesis.[15] Also, Samuelson published a proof showing that if the market is

efficient, prices will exhibit random-walk behavior.[16] This is often cited in support of the

efficient-market theory, by the method of affirming the consequent,[17][18] however in that same

paper, Samuelson warns against such backward reasoning, saying "From a nonempirical base of
axioms you never get empirical results."[19] In 1970, Fama published a review of both the theory

and the evidence for the hypothesis. The paper extended and refined the theory, included the

definitions for three forms of financial market efficiency: weak, semi-strong and strong (see

below).[20]

It has been argued that the stock market is "micro efficient" but not "macro efficient". The main

proponent of this view was Samuelson, who asserted that the EMH is much better suited for

individual stocks than it is for the aggregate stock market. Research based on regression and

scatter diagrams has strongly supported Samuelson's dictum.[21] This result is also the theoretical

justification for the forecasting of broad economic trends, which is provided by a variety of

groups including non-profit groups as well as by for-profit private institutions.[citation needed]

Further to this evidence that the UK stock market is weak-form efficient, other studies of capital

markets have pointed toward their being semi-strong-form efficient. A study by Khan of the

grain futures market indicated semi-strong form efficiency following the release of large trader

position information (Khan, 1986). Studies by Firth (1976, 1979, and 1980) in the United

Kingdom have compared the share prices existing after a takeover announcement with the bid

offer. Firth found that the share prices were fully and instantaneously adjusted to their correct

levels, thus concluding that the UK stock market was semi-strong-form efficient. However, the

market's ability to efficiently respond to a short term, widely publicized event such as a takeover

announcement does not necessarily prove market efficiency related to other more long term,

amorphous factors. David Dreman has criticized the evidence provided by this instant "efficient"

response, pointing out that an immediate response is not necessarily efficient, and that the long-

term performance of the stock in response to certain movements are better indications.
Theoretical background

Beyond the normal utility maximizing agents, the efficient-market hypothesis requires that

agents have rational expectations; that on average the population is correct (even if no one

person is) and whenever new relevant information appears, the agents update their expectations

appropriately. Note that it is not required that the agents be rational. EMH allows that when

faced with new information, some investors may overreact and some may underreact. All that is

required by the EMH is that investors' reactions be random and follow a normal distribution

pattern so that the net effect on market prices cannot be reliably exploited to make an abnormal

profit, especially when considering transaction costs (including commissions and spreads). Thus,

any one person can be wrong about the market—indeed, everyone can be—but the market as a

whole is always right. There are three common forms in which the efficient-market hypothesis is

commonly stated—weak-form efficiency, semi-strong-form efficiency and strong-form

efficiency, each of which has different implications for how markets work.

Weak-form efficiency[edit]

In weak-form efficiency, future prices cannot be predicted by analyzing prices from the past.

Excess returns cannot be earned in the long run by using investment strategies based on

historical share prices or other historical data. Technical analysis techniques will not be able to

consistently produce excess returns, though some forms of fundamental analysis may still

provide excess returns. Share prices exhibit no serial dependencies, meaning that there are no

"patterns" to asset prices. This implies that future price movements are determined entirely by

information not contained in the price series. Hence, prices must follow a random walk. This

'soft' EMH does not require that prices remain at or near equilibrium, but only that market

participants not be able to systematically profit from market 'inefficiencies'.[22] and that,
moreover, there is a positive correlation between degree of trending and length of time period

studied (but note that over long time periods, the trending is sinusoidal in

appearance).[23] Various explanations for such large and apparently non-random price

movements have been promulgated.

There is a vast literature in academic finance dealing with the momentum effect identified by

Jegadeesh and Titman.[24][25] Stocks that have performed relatively well (poorly) over the past 3

to 12 months continue to do well (poorly) over the next 3 to 12 months. The momentum strategy

is long recent winners and shorts recent losers, and produces positive risk-adjusted average

returns. Being simply based on past stock returns, the momentum effect produces strong

evidence against weak-form market efficiency, and has been observed in the stock returns of

most countries, in industry returns, and in national equity market indices. Moreover, Fama has

accepted that momentum is the premier anomaly[26][27]

The problem of algorithmically constructing prices which reflect all available information has

been studied extensively in the field of computer science.[28][29]

Semi-strong-form efficiency[edit]

In semi-strong-form efficiency, it is implied that share prices adjust to publicly available new

information very rapidly and in an unbiased fashion, such that no excess returns can be earned by

trading on that information. Semi-strong-form efficiency implies that neither fundamental

analysis nor technical analysis techniques will be able to reliably produce excess returns. To test

for semi-strong-form efficiency, the adjustments to previously unknown news must be of a

reasonable size and must be instantaneous. To test for this, consistent upward or downward

adjustments after the initial change must be looked for. If there are any such adjustments it
would suggest that investors had interpreted the information in a biased fashion and hence in an

inefficient manner.[citation needed]

Strong-form efficiency[edit]

In strong-form efficiency, share prices reflect all information, public and private, and no one can

earn excess returns. If there are legal barriers to private information becoming public, as with

insider trading laws, strong-form efficiency is impossible, except in the case where the laws are

universally ignored. To test for strong-form efficiency, a market needs to exist where investors

cannot consistently earn excess returns over a long period of time. Even if some money

managers are consistently observed to beat the market, no refutation even of strong-form

efficiency follows: with hundreds of thousands of fund managers worldwide, even a normal

distribution of returns (as efficiency predicts) should be expected to produce a few dozen "star"

performers.