Efficient market hypothesis

Assumptions

Beyond the normal utility maximizing agents, the efficient market hypothesis requires the 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 are rational (which is different from rational expectations; rational agents act coldly and achieve what they set out to do). 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 enough that the net effect on market prices cannot be reliably exploited to make an abnormal profit. 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 have different implications for how markets work.

Weak-form efficiency

* No excess returns can be earned by using investment strategies based on historical share prices or other financial data.

* Weak-form efficiency implies that Technical analysis techniques will not be able to consistently produce excess returns, though some forms of fundamental analysis may still provide excess returns.

* In a weak-form efficient market current share prices are the best, unbiased, estimate of the value of the security. Theoretical in nature, weak form efficiency advocates assert that fundamental analysis can be used to identify stocks that are undervalued and overvalued. Therefore, keen investors looking for profitable companies can earn profits by researching financial statements.

Semi-strong form efficiency

* Share prices adjust within an arbitrarily small but finite amount of time and in an unbiased fashion to publicly available new information, so that no excess returns can be earned by trading on that information.

* Semi-strong-form efficiency implies that Fundamental analysis techniques will not 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.

Strong-form efficiency

* Share prices reflect all information 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. Studies on the U.S. stock market have shown that people do trade on inside information.

* 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 though many fund managers have consistently beaten the market[citation needed], this does not necessarily invalidate strong-form efficiency. We need to find out how many managers in fact do beat the market, how many match it, and how many underperform it. The results imply that performance relative to the market is more or less normally distributed, so that a certain percentage of managers can be expected to beat the market. Given that there are tens of thousand of fund managers worldwide, then having a few dozen "star" performers is perfectly consistent with statistical expectations.

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