An Introduction to the Workings of Market Efficiency

Market efficiency is notion put forward by the Efficient Market Hypothesis (EMH), which was formulated by Eugene Fama in 1970. This idea suggests that the market is efficient, which means that the market reflects Finance Brokerage Forex Beginners all available information about a particular stock and/or market at any given time.

Fama received the Nobel Memorial Prize in Economic Sciences jointly with Robert Shiller and Lars Peter Hansen in 2013.

The EMH argues that no investor has an advantage over other investors because no one has access to information that’s not already widely available in the market.

Non-Predictability

The nature of the information does not have to be boxed by financial news or research alone. The information about political, social, and economic events will get partnered with how the investor perceives them, whether they’re true or just rumors, and this will be reflected in the stock price.

EMH tells us that as prices respond only to the information available in the market, and since all investors are generally privy to the same information, none of them will ever have the ability to outperform anyone else.

In efficient markets, prices are predictable Forex Broker List but random, so no investment pattern can be recognized. That means that a planned approach to investment cannot be consistently successful.

Arguments against the EMH

On the flip side, real worlds arguments can be made against the EMH. There are investors who have beaten the market, such as Warren Buffett who uses a strategy that focuses on undervalued stocks.

There are also portfolio managers who have better track records than others and there are investment houses with better research analysis than others.

Counter-arguments to the EMH propose that patterns exist. Also, the studies in the so-called behavioral finance, which look into the effects of investor psychology on stock prices, also reveal that investor are influenced by many biases like loss aversion, confirmation, and overconfidence biases.

Arguments for the EMH

Meanwhile, the EMH does not dismiss the possibility of market anomalies that result in generating superior profits. As a matter of fact, market efficiency does not require prices to be equal to fair value all the time.

Prices can be over or undervalued but only during random occurrences. As a result, they eventually revert back to their mean values, also known as mean reversal. Therefore, since the deviations from a stock’s fair price are in themselves random, the investment strategies that apparently beat the market can’t be consistent.

Further, the EMH argues that investors who beat the market simply had luck instead of pure skill. EMH followers argue that that’s because of the laws of probability. At any given, in a market with a massive number of investors, some are bound to outperform the others.

Degrees of Efficiency

Strong Efficiency

The strongest version, it states that all information, public and private, in the market are accounted for in the stock price.

Semi-strong Efficiency

This form of EMH tells us that all public information is priced into a stock’s current price.

Weak Efficiency

This type of EMH tells us that the past prices of a stock are reflected in today’s stock price.