Question

Explain market efficiency define the concept of market efficiency and the efficient market hypothesis (EMH).

a. Provide an argument that either supports or refutes the application of EMH.

Use research and examples of investors. i. Warren Buffet, Joel Tillinghast, Will Danoff – consistently do better than the market.

ii. Consider the risk with investing based on the EMH premise versus the risk of ignoring EMH.

Answer 1

Market efficiency can be defined on the basis of the degree to which the current prices of stocks in the market are reflective of all the available and relevant information. As per the efficient market hypothesis (EMH) it is not always possible for investors to outperform the stock markets as all the available information is already reflected in the current prices of the stock.

a. The argument that I will be providing will refute the application of EMH. I will make use of the example of Warren Buffet. My argument is based on the simple logic that no information about a company or a stock is perfectly distributed among the several investors and among the general population as well. As a result it is not possible for stocks to be reflective of all available information on a real time basis. There will be a lag and the magnitude of the lag will differ from one case to another.

Take the example of Warren Buffet. EMH says that investors should invest in indexes and exchange traded funds (ETFs). However Warren Buffet has profited by not buying in index funds but investing in stocks when they are undervalued. In moments of market downfall investors panic and exit their positions. This leads the stocks to be undervalued and in such time the stock prices are not reflective of all the available and relevant information. This is the time when Warren Buffet buys a stock (he buys them when they are undervalued) and holds onto them when the fair price is reflected.

ii. Risk with investing based on the EMH premise is that when the stocks are overvalued (in times of economic boom) the investors will not book a profit assuming that the stock is fairly priced. This leads them to lose on the chance of earning a good profit.

Risk of ignoring EMH arises in those cases where a strong from of EMH exists. In such a form the current stock prices fully reflect all public and private information. When this is the case in reality investors will run the risk of losing money if they attempt to outperform and time the market.