Efficient Market Hypothesis (EMH) - The efficient market hypothesis is the hypothesis that the prices of securities fully reflect all available information about securities. If the markets are efficient then the prices of securities already reflect all attainable information and therefore experiencing abnormal returns are more than likely experienced through luck.
Random Walk - The random walk is a notion that states stock price changes are random and unpredictable. Suppose there was a well-known equation that allowed stock holders to predict the price of a stock. Now let's say that this equation predicted that a stock that is currently selling for $100 was going to increase in price to $120. If this was the case then investors would start trying to buy the stock, but nobody would be willing to sell resulting in an immediate price increase to $120. The equation in the example could be thought of as information. Stock prices change with new information and as the example shows new information is already priced in the stock. Therefore, if all available information is already priced into the stock, the price changes are unpredictable. If price changes were predictable then the market would be inefficient because it is not immediately pricing in available information.
Competition is the source of efficiency
Why should we really expect stock prices to reflect all available information? If one were to do enough research and digging then he would surely be able to discover information that is not yet priced into the stock. However, the increase in returns would have to justify all of the money and time that all his extensive research cost.
Imagine a hedge fund that manages $10 billion. If through extensive research it could increase its returns by .001 then this hedge fund would be willing to spend $10 billion x .001 = $10 million on research even though it would only give them a .001 return. Through this competition for information the markets become efficient.
Not all markets are equally efficient. For example, emerging markets are less researched making them less efficient. Popular companies are much more researched therefore it will be more difficult to find information that has not yet been discovered and priced into their stock.
Different Versions of the Efficient Market Hypothesis
There are 3 different forms of the Efficient Market Hypothesis: the weak, semi strong, and strong forms.
Weak-Form Information hypothesis - Asserts that stock prices reflect all data that can be derived by examining market trading data such as historical prices, trading volume, or short interest. If this hypothesis is true then trend analysis would be ineffective because all past trend information is inexpensive and readily available. The signals would lose their value because they would immediately be reflected in the price.
Semi-Strong information hypothesis - stock prices reflect all available information. This includes historical trading performances (weak-form) and all publicly available information such as financial statements, fundamental data, management quality etc.
Strong-Form information hypothesis - The strong-form hypothesis states that stock prices reflect all relevant information. This includes weak-form and semi-strong form and also information that is not available to the public (insider information).
Technical Analysis
Technical Analysis - Technical analysis is the search for recurrent and predictable patterns in stock prices. Although technicians, sometimes called chartist, may recognize the value of fundamental data regarding the future economic information of a firm, they don't believe that such information is necessary for successful trading. The efficient market hypothesis implies that technical analysis is ineffective because all historical data is already priced into the stock. Once a useful technical rule becomes discovered and widely used, it will become self-destructive therefore technicians will search for new rules to replace old outdated technical rules. If everyone knows about a rule or strategy then it will no longer be useful because everyone is using it.
Fundamental Analysis
Fundamental Analysis - Fundamental analysis is the analysis of a stock's underlying company. Fundamental Analysis uses earnings, past financial statements, dividends prospects, company performance relative to their competitors, expectations of interest rates, and attempts to determine the risk associated with a firm in order to price its stock correctly. The hope of fundamental analysis is to find information that has not yet been discovered by the public. Fundamental Analysis is not as easy as just finding a well performing firm. Finding a good firm is easy, however once an investor finds it they must be willing to pay a high price for its stock since the competition for information has already driven the price up based on this fundamental information. There are many well financed, and well driven firms already seeking information which drives the price of a stock so discovering such information can be extremely difficult. The trick is not to find a good firm, but to find a firm that is better than everyone else's estimates. The same goes for finding a bad undervalued firm that is not as bad as everyone else's estimates.
Active and Passive Portfolio Management
It should be apparent that casual analysis of stocks will not be likely to pay off. Competition among investors seeking information ensures this. Only serious in depth analysis and uncommon techniques will be able to exploit inefficiencies (discrepancies) in the market in order to yield a profit. Also, these techniques and analysis are only useful for those who manage large portfolios because only then will the increase in returns associated with the analysis produce enough money to justify that time and money needed for such extensive analysis.
Passive Investment Strategy - In an efficient market, actively managing a portfolio is wasted time; therefore many investors take the passive investment strategy. The Passive investment strategy is simply buying a well-diversified portfolio without attempting to find mispriced securities. Using the passive investment approach investors will pay less fees and commissions due to the fact that there is not any underlying expensive research and analysis involved. A common passive investment strategy is to create an index fund.
Index Fund - An index fund is a fund designed to replicate the performance broad based index of stocks, for example the S&P 500. This index fund would replicate the S&P 500. By investing in an index fund investors obtain a well-diversified portfolio that is relatively inexpensive to manage.
Are Markets Efficient?
There is not much enthusiasm about the Efficient Market Hypothesis among professional portfolio managers. This hypothesis implies that all their research is just wasted effort and even worse costly to their clients. Consequently, this hypothesis has not been widely accepted on Wall Street. What is more debated is the level at which security analysis can improve investment returns. Before discussing empirical tests to measure how efficient the markets are we will first introduce three factors that will ensure that the debate of the level at which security analysis can improve returns will never be settled: The magnitude issue, the selection bias issue, and the lucky event issue.
The Magnitude Issue - The magnitude issue simply implies that only managers of large portfolios can benefit from finding minor discrepancies in the market. The minor discrepancies are too small to measure.
The Selection Bias Issue - If an investor discovered a strategy that consistently earned abnormal returns, he or she would keep it secret. If it was widely known then it would eventually be self-destructive. He or she would rather keep it secret in order to use it effectively. Therefore, we cannot truly evaluate the ability of portfolio managers to generate abnormal returns.
The Lucky Event Issue - Often portfolio managers are just lucky. The true test to see how good they are is to check their performance over a long period of time.
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