The efficient-market Hypothesis (EMH) is a theory that claims that asset prices fully reflect all available information and it is impossible to earn excess profits as compared to overall market returns on a consistent basis.
The stocks always trade at their fare value making it impossible for investors to either purchase undervalued stocks or sell stocks for inflated prices.
The theory is derived from Eugene Fama's work titled as "Efficient Capital Markets: A review of Theory and Empirical Work".
According to the theory,
- Prices adjust to every new information quickly and without any bias.
As a result, the current prices of the securities reflect all available information at any given point of time.
- As soon as there is any information that indicates that a stock is underpriced, the investors rush to buy the stock and immediately bid up its price to a fair level.
- The only way an investor can obtain higher returns is by chance or by purchasing riskier Investments since it is impossible to outperform the overall market through expert stock selection or market timing.
Three forms of Efficient Market Hypothesis:
EMH theory could be distinguished in three versions based on the speed with which information effects the share price and the idea of the meaning of term "all available information".
Weak Form:
The weak form of Efficient market theory claims that share prices already reflect all past publicly available information that can be obtained by examining market trading data such as the history of past prices, trading volume, open interest or any such data that are easily available and virtually costless to obtain.
Therefore future prices are independent of these type of publicly available historical information and consistent returns cannot be achieved by using them.
The past history of prices and trading volume is publicly available at minimal cost. Therefore, any information that was ever available from analyzing past prices has already been reflected in stock prices.
So it rejects the usefullness of technical trading strategies using indicators for consistent returns.
The weak form of EMH also assumes that the prices do not reflect any new information that is not yet publicly available and thus it opens up the possibility that better than average returns could be achieved by deep analysis and gathering information that is not yet available for the public.
The semi-strong form:
The semi-strong form of EMH claims that stock prices adjust immediately to any publicly available new information.
It includes in addition to past prices, fundamental data of the stock. For example- balance sheet, earnings release, new product release, accounting data etc.
According to the semi-strong form of EMH,
Strong form:
The strong form of EMH claims that prices
instantly reflects all information related to the stock, both public and private.
It even includes hidden 'Insider' information known to the company's CEO.
This version of the hypothesis is quite extreme and implies that no one can earn more than average returns than overall market as all information publicly available or privately held has already been factored in the prices.
Anomalies in Efficient Market Hypothesis:
There are some deviations and exceptions to the EMH theory and are referred as Efficient Market Anomalies.
Book to Market Ratios Effect:
Research have shown that portfolio of companies with high book-to-market ratios outperform portfolios with low book-to-market ratios.
P/E Effect:
The portfolios of low price-earnings (P/E) ratio stocks have higher returns than portfolio composed of high P/E stocks.
Small-Firm-in-January Effect:
Stocks of small companies (smaller capitalization) tend to outperform larger companies even after adjusting for risk using Capital Asset Pricing Model (CAPM).
Neglected-Firm Effect:
It has been observed that lesser known stocks generate more return subsequently over a period of time.
This effect is closely related to 'Small-firm Effect'. The small firms are generally neglected by large-institutional traders and investors. Therefore, almost all neglected firms are small firms.
The stocks always trade at their fare value making it impossible for investors to either purchase undervalued stocks or sell stocks for inflated prices.
The theory is derived from Eugene Fama's work titled as "Efficient Capital Markets: A review of Theory and Empirical Work".
According to the theory,
- Prices adjust to every new information quickly and without any bias.
As a result, the current prices of the securities reflect all available information at any given point of time.
- As soon as there is any information that indicates that a stock is underpriced, the investors rush to buy the stock and immediately bid up its price to a fair level.
- The only way an investor can obtain higher returns is by chance or by purchasing riskier Investments since it is impossible to outperform the overall market through expert stock selection or market timing.
Three forms of Efficient Market Hypothesis:
EMH theory could be distinguished in three versions based on the speed with which information effects the share price and the idea of the meaning of term "all available information".
Weak Form:
The weak form of Efficient market theory claims that share prices already reflect all past publicly available information that can be obtained by examining market trading data such as the history of past prices, trading volume, open interest or any such data that are easily available and virtually costless to obtain.
Therefore future prices are independent of these type of publicly available historical information and consistent returns cannot be achieved by using them.
The past history of prices and trading volume is publicly available at minimal cost. Therefore, any information that was ever available from analyzing past prices has already been reflected in stock prices.
So it rejects the usefullness of technical trading strategies using indicators for consistent returns.
The weak form of EMH also assumes that the prices do not reflect any new information that is not yet publicly available and thus it opens up the possibility that better than average returns could be achieved by deep analysis and gathering information that is not yet available for the public.
The semi-strong form:
The semi-strong form of EMH claims that stock prices adjust immediately to any publicly available new information.
It includes in addition to past prices, fundamental data of the stock. For example- balance sheet, earnings release, new product release, accounting data etc.
According to the semi-strong form of EMH,
- Fundamental analysts rely on publicly available earnings, financial statements and other fundamental information of the company to determine whether the stock is good or bad. If these information are publicly available then other analysts and rest of the market would also know about the good and bad figures of the stock and it would already reflect in its prices.
- Discovery of good stocks does no good to an Investor if the rest of the market also knows those stocks are good.
- Therefore, the semi-strong form of EMH theory defies the capability of fundamental analysis along with technical analysis for the prediction of future price movements.
- Therefore no excess returns can be achieved by trading on such information related to recent events and current financial statements.
Strong form:
The strong form of EMH claims that prices
instantly reflects all information related to the stock, both public and private.
It even includes hidden 'Insider' information known to the company's CEO.
This version of the hypothesis is quite extreme and implies that no one can earn more than average returns than overall market as all information publicly available or privately held has already been factored in the prices.
Anomalies in Efficient Market Hypothesis:
There are some deviations and exceptions to the EMH theory and are referred as Efficient Market Anomalies.
Book to Market Ratios Effect:
Research have shown that portfolio of companies with high book-to-market ratios outperform portfolios with low book-to-market ratios.
P/E Effect:
The portfolios of low price-earnings (P/E) ratio stocks have higher returns than portfolio composed of high P/E stocks.
Small-Firm-in-January Effect:
Stocks of small companies (smaller capitalization) tend to outperform larger companies even after adjusting for risk using Capital Asset Pricing Model (CAPM).
Neglected-Firm Effect:
It has been observed that lesser known stocks generate more return subsequently over a period of time.
This effect is closely related to 'Small-firm Effect'. The small firms are generally neglected by large-institutional traders and investors. Therefore, almost all neglected firms are small firms.
 | Forms of EMH){kind=link}
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