Question

5

Do you think the widespread belief in the Efficient Market Hypothesis caused investors to underestimate the likelihood of a crisis?

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Answer 1

The efficient market hypothesis postulates that the price of a security incorporates all the available information about the security and an investor cannot gain an edge over the market by using/studying available information. In perform form of the theory, it states that all securities are trading at fair value and hence there is no concept of undervalued or over valued stocks, and an investor cannot beat the market by trying to find mispriced assets. This is taken to mean that the current price is also expected to incorporate all the known risks and future expectations about the securities and markets in general. This may not be correct but a misplaced confidence in this theory leads to the investors to believe that the current market prices represent fairly all the available information and risks. This leads investors to take irrational decisions which can lead to a crisis. However we need to understand that the conditions stated in the theory are not all truly present in real world and we have instances of information being withheld or prefrentail information being available to certain set of investors/issuers which allows them to make abnormal profits. Hence in the real world there are times when the markets will be over valued and undervalued which correspond to boom and bust cycles in the market. Thus the problem is not with the theory but with the understanding and misplaced confidence with the results of the theory.