Efficient-market hypothesis

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. Critics have blamed the belief in rational markets for much of the late-2000s financial crisis. 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. 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. It has been speculated that Bachelier drew ideas from the random walk model of Jules Regnault, but Bachelier did not cite him, and Bachelier's thesis is now considered pioneering in the field of financial mathematics. 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, which was cited by mathematicians including Joseph L. Doob, William Feller and Andrey Kolmogorov. 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. 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, F.A. 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. Empirically, a number of studies indicated that US stock prices and related financial series followed a random walk model in the short-term. 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. 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. In 1965, Eugene Fama published his dissertation arguing for the random walk hypothesis. Also, Samuelson published a proof showing that if the market is efficient, prices will exhibit random-walk behavior. This is often cited in support of the efficient-market theory, by the method of affirming the consequent, however in that same paper, Samuelson warns against such backward reasoning, saying 'From a nonempirical base of axioms you never get empirical results.' 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).