By Peet Serfontein.
The Efficient Market Hypothesis (EMH) is a fundamental concept in financial economics that has significant implications for investors and policymakers. It suggests that financial markets are "informationally efficient," meaning that the prices of securities at any given time fully reflect all available information. The EMH has profound implications on investment strategies, risk management, and financial regulation.
The EMH was first put forward by Eugene Fama in his doctoral dissertation at the University of Chicago in the 1960s. Fama's work was influenced by earlier theorists, including Bachelier and Samuelson, who made significant contributions to the theory of price movements in financial markets.
Key concepts attached to the EMH
The Random Walk Theory is a fundamental concept in financial economics, suggesting that equity price changes are random and unpredictable. This theory posits that the future path of an equity's price is independent of its past behaviour, implying that historical data on prices and volumes cannot be used to predict future price movements accurately.
The essence of this theory is that the market's behaviour is akin to a random walk, where each step or movement in price is random and detached from previous steps. This randomness is attributed to the market's quick reaction to new information, which is immediately factored into equity prices. The theory gained prominence in the 1960s and has since been a critical argument against the effectiveness of technical analysis, a method that relies on patterns in historical data to predict future equity prices. According to the Random Walk Theory, since price changes are essentially a "coin flip", attempting to forecast future movements based on past trends is futile.
Informational efficiency is closely related to the Random Walk Theory and a cornerstone of the EMH, being that equity prices at any given time reflect all available information. This concept suggests that it is impossible for investors to consistently achieve returns more than average market returns on a risk-adjusted basis, given that all known and relevant information is already incorporated into equity prices. In an informationally efficient market, new information, whether about a specific company, industry, or the economy, is quickly and accurately absorbed, and equity prices adjust accordingly. Informational efficiency implies that the only way an investor can potentially achieve higher-than-average returns is through luck or obtaining and trading on information that is not yet available to the public. As such, this concept challenges the value of investment strategies based on fundamental analysis, which seeks to determine a company's intrinsic value by examining related economic and financial factors.
The EMH exists in three forms
This hypothesis is categorised into three distinct forms, each addressing the degree to which different categories of information are reflected in market prices.
Criticism of the EMH
Despite its widespread acceptance, the EMH faces several criticisms.
The active versus passives debate
The debate between active and passive investment strategies is deeply influenced by beliefs in the EMH and the perceived level of market efficiency. Active investing operates on the principle that markets are not fully efficient, allowing for opportunities to outperform market indices through strategic equity selection and timing. This approach typically involves intensive analysis and trading with the aim to exploit mispricing in the market. However, it often comes at a higher cost and the challenge of consistently beating the market, which the EMH suggests is difficult over the long term.
Conversely, passive investing is rooted in the assumption that markets are efficient, making it hard to consistently outperform market averages. Passive strategies focus on long-term investment in broad market indices or diversified portfolios, minimising trading costs and the need for active management. This approach aligns with the EMH, especially its semi-strong and strong forms, positing that all available information is already factored into equity prices, thereby diminishing the potential for above-average returns through active management.
The choice between active and passive investing depends on an investor's belief in market efficiency, risk tolerance, and investment goals. The ongoing active versus passive debate reflects the complex and dynamic nature of financial markets and the diversity of investment philosophies.
