Efficient Market Hypothesis

Definition

The efficient market hypothesis (EMH) is an investment theory that states that financial markets are 'informationally efficient', meaning that asset prices fully reflect all available information. This suggests that it is impossible to consistently outperform the overall market through expert stock selection or market timing, and that the best investment strategy is to invest in a diversified portfolio.

5 Must Know Facts For Your Next Test

1. The efficient market hypothesis suggests that actively managed funds are unlikely to outperform the broader market over the long-term.
2. EMH is based on the assumption that markets are highly competitive, with many well-informed and rational investors constantly seeking to profit from new information.
3. Proponents of EMH argue that attempts to time the market or pick 'winning' stocks are futile, and that the best investment strategy is to hold a diversified portfolio that tracks the overall market.
4. Critics of EMH point to market anomalies, such as the January effect and the value premium, as evidence that the market is not perfectly efficient.
5. The degree of market efficiency can vary, with some markets (e.g., large-cap stocks) being more efficient than others (e.g., small-cap stocks or emerging markets).

Review Questions

• Explain how the efficient market hypothesis relates to the concept of the 'Great Deregulation Experiment'.
  • The efficient market hypothesis is closely tied to the 'Great Deregulation Experiment' in that it suggests financial markets are inherently efficient and self-regulating. Proponents of EMH argue that heavy regulation and government intervention are unnecessary, as market forces will naturally correct any inefficiencies. This aligns with the deregulatory policies implemented during the 'Great Deregulation Experiment', which aimed to reduce government oversight and allow financial markets to operate more freely. The belief that markets are informationally efficient and that active investment strategies cannot consistently outperform the market underpins the rationale for deregulation and a hands-off approach to financial market oversight.
• Analyze how the efficient market hypothesis has influenced the development of index funds and passive investment strategies.
  • The efficient market hypothesis has had a significant impact on the growth of index funds and passive investment strategies. If markets are truly efficient and it is impossible to consistently outperform the market, then the best investment approach is to simply hold a diversified portfolio that tracks the overall market. This has led to the rise of index funds, which aim to replicate the performance of a broad market index, such as the S&P 500. Passive investment strategies based on the efficient market hypothesis have become increasingly popular, as they offer low-cost, hands-off exposure to the market and have often outperformed actively managed funds over the long-term. The widespread acceptance of the efficient market hypothesis has been a key driver in the shift towards passive investing and the increased popularity of index funds.
• Evaluate the criticisms and limitations of the efficient market hypothesis, particularly in the context of the 'Great Deregulation Experiment'.
  • While the efficient market hypothesis has been influential, it has also faced significant criticism and limitations, especially in the context of the 'Great Deregulation Experiment'. Critics argue that markets are not always perfectly efficient, and that there are numerous market anomalies and behavioral biases that can lead to mispricing and inefficiencies. The financial crises and market volatility experienced during the 'Great Deregulation Experiment' have been used as evidence against the EMH, as they suggest that markets are not always self-correcting and can experience significant disruptions. Additionally, the rise of high-frequency trading, information asymmetries, and the influence of large institutional investors have led some to question the validity of the EMH in modern financial markets. These criticisms have prompted a re-evaluation of the role of regulation and government oversight in ensuring the stability and efficiency of financial markets, challenging the deregulatory policies implemented during the 'Great Deregulation Experiment'.

Related terms

Informational Efficiency: The concept that all relevant information is already reflected in an asset's price, making it impossible to consistently achieve returns higher than the overall market.

Random Walk Theory:

The idea that asset price movements are random and unpredictable, making it impossible to consistently outperform the market through active investment strategies.

Market Anomalies: Instances where asset prices deviate from what the efficient market hypothesis would predict, potentially allowing for market-beating returns.