BUS FPX 4070 Assessment 5 Efficient Market Hypothesis (EMH)

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Capella University

BUS-FPX4070 Foundations in Finance

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The Efficient Markets Hypothesis (EMH)

Efficient markets are achieved when security prices accurately and fully reflect all market information. In theory, an efficient market should result in rational share price adjustments in relation to relevant market news. Efficient market hypothesis (EMH) is also a financial economic theory that minimizes the need for financial market analysis, or the possibility of economic profits by trading. Many market participants maintain opposition to EMH due to historical market volatility that can seemingly not be explained by objective economic events or related information. Moreover, EMH concludes that buying and holding a diversified portfolio of stocks with similar risk is an adequate investment technique rather than searching for anomalies and undervaluations in the market.

The Three Levels of Market Efficiency

According to EMH, the relevant information that affects financial markets can be broken into three levels: weak form, semi-strong form, and strong form. Weak form EMH includes historical market data. Semi-strong EMH includes financial statement data, and strong form of EMH includes privileged insider data. Despite the existence of these three information sets, an efficient market will still eliminate the possibility of superior investment results or abnormal profits according to theory.

In the weak form of EMH, analyzing past price patterns to predict price changes in the future is criticized as inconsistent. Departures from previous prices are not uncommon and often occur due to unpredictable news. This would make price prediction investment strategies resist extraordinary profits in an efficient market.

BUS FPX 4070 Assessment 5 Efficient Market Hypothesis (EMH)

The semi-strong form of EMH considers publicly available information such as financial statements and company announcements. Many investment professionals study this information to predict undervaluations for potential profits from trading; however, the rapid price adjustment after new information in an efficient market would make extraordinary profits minimal.

Interestingly, the strong form of EMH suggests that public anticipation of insider information and major company announcements can also prematurely and consequently affect share prices in a way that would even render insider information ineffective for extraordinary trading profit. Bans on insider trading also affect the absence of speculation due to privileged information in an efficient market.

Implications of the EMH on Financial Decisions

There are supporters and opponents of EMH and each of its three levels. EMH studies and its anomalies mostly show that investment professionals should have awareness of the basis for their investment strategies to properly maximize shareholder wealth. As Markiel (1989) explains, “market valuations rest on both logical and psychological factors.” An investment professional or stock market investor should consider EMH rationality and crowd psychology when making financial decisions. Even with the existence of speculative trading using historical price predictions, financial statement analysis, and insider trading, an efficient market will adjust accordingly to still benefit investors that simply buy and hold a diversified stock portfolio equally. Tax considerations and management/transaction fees are important equalizers to consider as well when choosing a stance for financial decisions that properly benefit shareholders.

References

Malkiel, B. G. (1989). Is the stock market efficient? Science, 243(4896), 1313–1318.

BUS FPX 4070 Assessment 5 Efficient Market Hypothesis (EMH)