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The efficient market hypothesis refers to a term used to describe a financial economics theory, which posits that the prices of assets are a reflection of the information available to investors at a particular point in time. A market is described as being efficient when it contains a multitude of rational investors whose key focus is on profit maximization and who are engaged in active competition with each investor attempting to make predictions about the market value of various securities in the future (Shiller, 2003). Besides this, there is the free availability of all vital current information in this market. Hence, because of the competition existent among the multitude of intelligent market players, the actual price of a given security at any a particular period reflects the effects of information resulting from both past and future expected events (Fama, 1970). Thus, one can say that the prevailing prices of securities in efficient markets at any given time are reasonable estimates of the intrinsic values of those securities. The hypothesis is typically presented in three manifestations, which are the weak, the semi-strong, and the strong forms, all of which have differing effects on the working of the market.
This hypothesis posits that security prices are indicative of the information obtained by examining data related to market trading for example trading volumes and past price trends (Fama, 1970). Weak form efficiency further holds that trend analysis is non-beneficial and cannot help an investor to earn high returns in the long run. The reasoning underlying this position is that historical information on security prices is freely and publicly available and hence if signals about future stock performance were contained in that data, all investors would already have acted on the signals thus occasioning thus causing them to lose value (Fama, 1970).
This theory implies that security prices must reflect any data relating to an entity’s prospects that is in the public domain (Shiller, 2003). Besides data on past stock prices, such information may relate to an entity’s accounting policies, projected earnings, analysis of the strength of the organization’s management, and data relating to the company’s products. According to this hypothesis, the prices of securities in the market react to the availability of such information in a rapid, unbiased manner, which means that investors cannot earn better returns by making trades based on this information (Fama, 1970). Hence, neither technical nor fundamental analysis techniques can assist an investor to obtain extra returns reliably. In the market, the test for the existence of semi-strong efficiency is the presence of adjustments to information that was previously unknown with these adjustments being instantaneous and of reasonable size (Malkiel, 2003). These modifications, which can be either downward or upward, typically imply that the investors’ interpretation of the information was biased and thus inefficient.
Strong form efficiency
Under this category of the efficient markets hypothesis, the primary argument presented is that the prices of securities reflect any information that has some relevance to an entity including that known only to the organization’s insiders (Fama, 1970). In any entity, the corporate officers often obtain pertinent information long before it is made known to the public. Consequently, organization insiders are finely poised to profit excellently from making trades based on that knowledge. Market regulators, in an attempt to stem this, typically impose limits on trading by substantial owners, directors, and other insiders and require that such dealings must be reported (Shiller, 2003).
Reasons for market inefficiency
When a financial market is described as being efficient, the implication is that such a market does not permit an investor to obtain returns that are above average without accepting a comparable level of risk (Shiller, 2000). However, the existence of anomalies in the marketplace sometimes causes the efficiency of some markets to suffer from a substantial degree of impairment. Market efficiency is primarily dependent on the presence of three conditions, which are rationality of the investors, arbitrage, and independent or non-random deviations from the prevalent rationality (Schwert, 2003). The maintenance of market efficiency is predicated on the satisfaction of any one of these conditions, whereas the absence of all three leads to market anomalies and thus irrationality.
The first condition, rationality, assumes that all investors in a securities market are rational, which means that when a firm releases relevant information to the market, all the investors will make reasonable adjustments to their estimates of the firm’s stock prices (Shleifer, 2000). However, this is seldom the case because most investors are hardly ever rational and fail to achieve the appropriate level of diversification. For many investors, frequent trading and the associated higher taxes and brokerage fees are the order of the day. Investors do not recognize that they can minimize these expenses by merely holding winners and selling losers (Shleifer, 2000). Hence, because such a large number of investors lack rationality, the satisfaction of this condition is unrealistic in the real world, which brings about inefficiency.
The presence of non-random deviations from rational behavior is the second necessary condition for market efficiency. This requirement means that if, for example, some investors were skeptical about a company’s announcement, there would be other investors in the same market who would be over-optimistic about that announcement (Shleifer, 2000). Consequently, these two groups would end up canceling one another thus causing the stock to move rationally. However, because these market deviations are not random, it is highly unlikely that they would cancel each other out among the entire investor population in a market (Shleifer, 2000). Investors often overvalue some upcoming sectors such as biotechnology and IT leading to market bubbles, which cannot be explained using the hypothesis. Similarly, sometimes investors may be so conservative such that they are too slow to adjust to the presence of new information thus resulting in delayed price adjustment.
The third condition, arbitrage, is a term that describes the process through which investors exploit under and overpricing of securities for financial gain (Shleifer, 2000). When there is underpricing of some securities, arbitrageurs purchase those securities that will haul prices to the equilibrium while simultaneously disposing of the overpriced ones. Consequently, at any time, the pricing of the securities will be correct. Theoretically, arbitrage is a risk-free process, but practically, the reality is different. Arbitrageurs may experience various risks such as fundamental risk, which arises from the lack of perfect substitutes for mispriced securities (Shleifer, 2000). Noise trading risk, which is the risk that the mispricing that the arbitrageurs are exploiting will worsen in the short run, may cause investors to engage in early liquidation thus potentially leading to steep losses (Shleifer, 2000). Implementation costs are another inhibitor of arbitrage with brokerage, taxes, and other transaction costs reducing the attractiveness of arbitrage. Because of these risks, many investors may be unwilling to participate in arbitrage thus rendering the market inefficient.
Conclusively, this hypothesis, which proposes the existence of three manifestations of efficiency in marketplaces, is fundamental to financial economics. Classification in either category is dependent on the nature of the data that is reflected in the market prices of securities. The theory primarily holds that the intense levels of competition inherent in capital markets cause the fair pricing of securities thus rendering it impossible to profit from the possession of past, present, or future information relating to a firm’s stocks. However, efficient marketplaces are subject to various inhibitors like the existence of irrational investors whose irrationality may connect across multiple groups instead of canceling out and the riskiness of arbitrage as a strategy.
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