Efficient Market Hypothesis - EMH

There are many people that claim a stock is a "strong buy" or that they know a stock price is going to increase or decrease substantially. They might be neighbors, relatives, authors of websites or newspaper articles, or even so-called "expert analysts." Many websites in particular, claim that they have found a pattern to get rich quick off of stocks. Analyzing this type of claim leads to a different conclusion - the Efficient Market Hypothesis.

If someone truly has information that will lead to above normal returns, he has two options: share it with others at a price or to get fame, or make above normal returns by investing himself. If he makes above normal returns by himself, then it is likely that he'll have a lot of money rather quickly. If he shares the information with others, the information will soon become useless.

For example, if I tell others that stock ABC is going to increase 100% by next week and they believe me, then they will go out and immediately buy stock ABC, forcing it to increase by 100%. After this point the stock has already increased by 100% and my information is no longer valid.

Stock prices reflect the proper risk-return relationship (given a certain amount of risk people expect a certain amount of return). If new information is released that changes the risk or the expected return of a stock, all who know the information will react immediately until the stock is again at its proper value. Because of this we can infer that only new information will affect a stock's price. Of course, if investors can predict new information then they will buy or sell accordingly before the new information is "released"--making it part of today's information. Again the price of the stock will reflect the available information. This means that stock prices will only change in response to new, unpredictable information that comes randomly.

If stock prices only respond to new, unpredictable information that comes randomly, then stock prices themselves will change randomly. This is known as random walk. This doesn't mean that stocks are priced irrationally, it means that new information comes randomly and large groups of investors react rationally. The Efficient Market Hypothesis is the notion that stock prices (or prices in any market) already reflect all known information.

The efficient market hypothesis can be divided into three subgroups that reflect different beliefs of the degree of efficiency:

Weak-Form Efficiency

weak-form efficiency holds that stock prices already reflect all information that can be obtained from examining historical data--including historical prices, trading volume, charts, etc. Historical data is virtually free and easy to obtain and is therefore worthless because it has already been fully exploited.

Semistrong-Form Efficiency

In addition to historical data, semistrong-form efficiency holds that all publicly available information about firms are already reflected in the stock prices. This rules out fundamental analysis as a way to obtain excess returns.

Strong-Form Efficiency

Strong-form efficiency holds that stock prices reflect all information available, including inside information, and no one can consistently earn excess returns over an extended period of time. This view of the efficient market hypothesis is extreme. Nearly every day earnings reports are released and stocks react accordingly.

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