Question

Briefly explain the “efficient markets hypothesis”. What criticisms have been levelled against it? Discuss.

Answer 1

Efficient Market Hypothesis (EMH)

The theory that holds that an asset's price reflects all relevant information. When new information comes out, the price will change rapidly and accurately to reflect this information.Differences in returns on assets are always explained by differences in risk, or a random result.Investors cannot earn higher risk-adjusted returns than average on a consistent basis by using publicly available information to guide their investing decisions.

Three Types of Efficient market hypothesis

Weak EMH.

This states all past market prices and data are fully reflected in the price of securities and stocks. However, some information about events shaping the company may not be fully reflected in the price. In other words, technical analysis of prices is of no use.

Semistrong EMH.

This states asserts that all publicly available information is fully reflected in securities prices. In other words, fundamental analysis is of no use.

Strong Form of EMH

This asserts that all information is fully reflected in securities prices. In other words, even insider information is of no use.

Criticism

Irrational exuberance

It refers to a situation where economic agents develop confidence in the economy and financial markets that is misplaced. Consumers, bankers and firms become overly confident and expect asset prices to keep rising and growth to remain strong. Irrational exuberance is a factor behind the financial crisis.

People get carried away by booms and asset bubbles (e.g. US house prices in the 2000s, Dot Com Bubble and Bust.

Behavioural economics

Behavioral Economics places greater emphasis on the irrationality of human behaviour in making economic decisions e.g. herding effect etc.