One of the most popular and controversial topics in the entire field of finance is the efficient market hypothesis. This topic fascinates me, and is central to my investment philosophy. The following excerpt from my dissertation gives a brief overview of the hypothesis.

The belief in market efficiency has dominated mainstream academic finance since Eugene Fama, Professor of Finance at Chicago, published his article Efficient Capital Markets: A Review of Theory and Empirical Work in the Journal of Finance in 1970. This was certainly not the first time the idea of market efficiency had been presented (Regnault, 1863; Bachelier, 1900; Cowles, 1933;Mandelbrot, 1963; Samuelson, 1965; Fama, Fisher, Jensen, & Roll, 1969) but at this point the idea that markets are rational became the mainstream view.

The efficient market hypothesis postulates that information regarding the value of securities is quickly and completely imputed into the value of assets, and that investors impute this value in a rational manner. In other words, prices “fully reflect all available information.”(Fama, 1991).

The theory provides for three degrees of market efficiency, dubbed “forms” of the efficient market hypothesis; weak-form, semi-strong form, and strong-form (Fama, 1970).

In a weak-form efficient market, past price movements are the only information about a security on which an investor cannot make an abnormal profit by trading. All other information concerning a securities value can be used to gain an advantage. This is said to be weak efficiency because of the vast amount of information that is not completely imputed into security value (Fama, 1970).

In the semi-strong form, the efficient market hypothesis states that all publicly available information is already incorporated into a securities price, and therefore, cannot be acted upon in order to gain an abnormal profit. This means that only private information, not disclosed to the public, may be used to gain an advantage because it has not been incorporated into a securities value. If an individual has information concerning the value of a security that is private, they may trade securities on this information and gain a profit from their informational advantage. Of course, this is expressly prohibited as “insider trading” (Fama, 1970).

A strong-form efficient market is a market in which all information, to include inside information, is anticipated by the market and incorporated into security prices. This leaves no room for gaining an informational advantage, and no trading strategy that relies on such information can be expected to gain an advantage over the market (Fama, 1970).

In order for markets to be efficient, they must also be rational. There are two possibilities for achieving market rationality. The first is that each individual agent within the market behaves rationally and makes each decision in a rational manner. The second possibility for achieving market rationality involves a market with some individually irrational agents, with two distinct characteristics. The first is that the irrational decisions made by these agents are sufficiently random as to be offsetting and bring the market to rest on a rational equilibrium. This underlies what is referred to as the “Random Walk” in finance literature (Working, 1934; Cowles & Jones, 1937; Mandelbrot, 1963; Fama, 1965). The second characteristic of a rational market containing irrational agents is that the rational agents, seeking to maximize their own utility, will take actions that counteract the irrational agents and thus bring the market to a rational equilibrium in a process known as arbitrage (Friedman, 1953; Shleifer, 2000).

There has been significant interest and research regarding the efficiency of markets (Ang, Goetzmann, & Schaefer, 2011). This study I conducted is related to that body of research and carries implications for the rationality of investors and, by extension, the market.

There is a lot more to talk about, and I’m sure I’ll get to it in future posts. One of my favorite books is The Myth of the Rational Market by Justin Fox. I have owned this book since shortly after it was published and I read it again every few years. I think he does a great job of laying out the development of the theory from a historical perspective. Its a comfortable read, but very informative.

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References:

Ang, A., Goetzmann, W., & Schaefer, S. (2011). Review of the Efficient Market Theory and Evidence: Implications for Active Investment Management. Hanover, MA: Now Publishers.

Bachelier, L. (1900). Theorie de la Speculation. Annales Scientifiques de l’Ecole Normale Superieure Ser. 3(17), 21-86.

Cowles, A. (1933). Can Stock Market Forecasters Forecast? Econometrica, 1, 309-324.

Cowles, A., & Jones, H. (1937). Some A Posteriori probabilities in Stock Market Action. Econometrica, 5, 280-294.

Fama, E. (1991). Efficient Capital Markets: II. Journal of Finance, 46(5), 1575-1617.

Fama, E. (1965). Random walks in stock market prices, Financial Analysts Journal 21, 55-59.

Fama, E. (1970). Efficient Capital Markets: A Review of Theory and Empirical Work. Journal of  Finance 25, 383-417.

Fama, E., Fisher, L., Jenson, M., & Roll, R. (1969). The adjustment of stock prices to new information. International Economic Review, 10(1), 1-21.

Friedman, M. (1953). The case for flexible exchange rates. Essays in positive economics. Chicago, IL: University of Chicago Press.

Mandelbrot, B. (1963). The Variation of Certain Speculative Prices. Journal of Business, 36, 394-419.

Regnault, J. (1863). Calcul des Chances et Philosophie de la Bourse. Paris: Mallet Bachelier and Castel.

Samuelson, P. A. (1965). Proof that Properly Anticipated Prices Fluctuate Randomly. Industrial Management Review, 6, 41-49.

Shleiffer, A. (2000). Inefficient Markets: An Introduction to Behavioral Finance. Oxford: Oxford        University Press.

Working, H., (1934). A random-difference series for use in the analysis of time series. Journal of the American Statistical Association, 2(185), 11-24