Question

10.   Efficient Market Hypothesis
a.   Describe in 100 words or less what it means when we say the capital market is efficient and outline its implications.                  
b.   If the capital market is efficient, does it mean you can expect to do well as the market by randomly picking stocks to form a portfolio? Explain why or why not.                                       

Answer 1

a)

The efficient market hypothesis states that the current market price is an reflection of all the information available about the stock currently. Further, it states that any new information is incorporated in the stock price in negligible amount of time, hence any attempt to consistently outperform the market return is not possible. There are 3 forms of efficient market hypothesis - Weak form (stock price reflects all the past information), semi-strong form (stock price reflects all the publicly available information) and strong form (stock price reflects all the information, irrespective of it being public or private).

The implication of this is that the stock price follows a random walk, ie the future stock price has no correlation with the price movements earlier. Due to this the stock price is completely unpredictable and hence markets cannot be outperformed consistently.

b)

No, you cannot expect to do well for a very long time as the market by randomly picking stocks to form a portfolio if the capital market is efficient. If the capital market if efficient, all the available information is already priced in the stock price. Hence, any active portfolio strategy would be ineffective in the long run as the market returns cannot be outperformed.