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Definition: Efficient Market Hypothesis – EMH
It is also popularly known as Random Walk Theory which states that current security prices reflect all the relevant information available and there is no way in which an investor can earn excess profits or “beat the market”.
The term “efficient market” was coined by Eugene Fama who said that new information will be reflected instantaneously in actual prices. EMH suggests that main driver behind price changes is arrival of new information and prices adjust quickly without any bias towards new information. Hence identifying undervalued stocks is futile exercise. Stock prices adjust before an investor has time to react or profit from new information because of existing intense competition among investors. The EMH theory can be put into a slogan which is “Always trust market prices!” Also expected return from a stock is dependent on the risk associated with it and current market price reflects present value of expected future cash flows which incorporates various factors such as liquidity, volatility and risk of bankruptcy.
EMH also states that there are different kinds of information that affects stock prices. They are: -
• Weak Form Efficiency: - It asserts that current prices contain all the information of historical prices and also past information. Hence nobody can beat the market by analysing past prices. It states that stock prices are something that everybody knows hence one will not be able to profit from information that everybody else knows. Hence investors trying to predict stock value using technical analysis will not be benefited from it.
• Semi Strong Form Efficiency: - It stipulates that current prices completely reflect all the publicly available information. Public information includes not only past prices but also data reported in company’s financial disclosures such as balance sheets, profit and loss statement or cash flow, earning and dividend announcements, mergers and acquisitions and macroeconomic factors. The assertion remains same that one will not be able to profit from information that is available to everybody else but this information is far stronger than that of weak form efficiency. It is because analysis of such vast information will bring out different interpretations for everybody and also it will take a lot of time and effort to gain this information. Company produced publications and major newspapers contribute only small part of information and one has to follow wire reports, local papers, research journals and different publications to find all sorts of information. Hence this information carries some influence on market prices.
• Strong Form Efficiency: - It asserts that current prices fully incorporate all publicly and privately held information. The major difference between strong and semi strong efficiency hypothesis is that in the former case nobody should be able to benefit even if trading on information not public yet. It states that even company’s management will not be able to benefit from inside information by buying company’s shares as soon as a new decision is taken. Similarly the members of the research department of a company will not be able to profit from a new invention. The rationale for this is market has in its own way and in an unbiased manner anticipated these kinds of changes and future developments and therefore the stock prices reflect incorporating all kinds of information.