Question

In your own words, what is the efficient market hypothesis?

Answer 1

Efficient Market Hypothesis

The markets quickly reflect information relevant to the value of a security.The idea of market efficiency is called The Efficient Market Hypothesis (EMH) theory. Efficient market hypothesis (EMH) states that a market is efficient if security prices immediately and fully reflect all available relevant information. Efficient means informationally efficient, not operationally efficient. Operational efficiency deals with the cost of transferring funds. If the market fully reflects information, the knowledge that information would not allow anyone to profit from it because stock prices already incorporate the information.

The Hypothesis has 3 forms,

1.Strong Form

2.Semi strong Form

3.Weak Form

Strong Form

The strong form of the theory states that all information (Public or private) is incorporated in a security price. Therefore, it is not possible for insider to earn abnormal profits.

Semi strong Form

It states that all publicly available information (no private information) is incorporated in a security price. Therefore, abnormal profits from insider trading are possible.

Weak Form

The weak form of the theory says that security prices reflects all recent price movements only. Therefore, technical analysis will not provide a basis for abnormal returns.

Here an Investor examines recent research related to behavioral finance, momentum investing, and popular fundamental ratios that purports to contradict the theory and concludes that it is not significant in the long run. Therefore, in his view, the efficient market hypothesis remains valid.The efficient market hypothesis holds that when new information comes into the market, it is immediately reflected in stock prices; neither technical analysis (the study of past stock prices in an attempt to predict future prices) nor fundamental analysis (the study of financial information) can help an investor generate returns greater than those of a portfolio of randomly selected stocks.The efficient market hypothesis may help an investor to understand the whole market condition by only looking stocks.