What is the Efficient Market Hypothesis?


In the 1960's Eugene Fama submitted his Ph.D. dissertation. In it he argued: that in any market that has “many well informed agents” i.e. traders, the current price reflects all of the available information. By 1970 this idea evolved into the first of three papers (“Efficient Capital Markets: A Review of Theory and Empirical Work”) he would publish paper that would come to be known as the Efficient Market Hypothesis or EHM for short. EMH asserts that because markets are “efficient”, any analysis a person does is a wasted effort. What it basically says is that people who buy and sell securities (stocks) are wasting their time trying to find “good deals”. Furthermore, it is impossible to outperform the market and that anyone who does simply “lucky”. Apparently there are a alot of lucky people out there.

Of course, the definition of EMH begs the question: What exactly is a “efficient” market? It seem there is no consensus and the experts' answers are constantly changing.

‘An 'efficient' market is defined as a market where there are large numbers of rational, profit-maximizers actively competing, with each trying to predict future market values of individual securities, and where important current information is almost freely available to all participants. In an efficient market, competition among the many intelligent participants leads to a situation where, at any point in time, actual prices of individual securities already reflect the effects of information based both on events that have already occurred and on events which, as of now, the market expects to take place in the future. In other words, in an efficient market at any point in time the actual price of a security will be a good estimate of its intrinsic value.’
Eugene F. Fama, "Random Walks in Stock Market Prices," Financial Analysts Journal, September/October 1965
‘an "efficient" market, i.e., a market that adjusts rapidly to new information.’
Fama et al. (1969)
‘A market in which prices always “fully reflect” available information is called “efficient.”’
Fama (1970)
‘A market is efficient with respect to information set θt if it is impossible to make economic profits by trading on the basis of information set θt.’
[‘By economic profits, we mean the risk adjusted returns net of all costs.’]
Jensen (1978)
‘I take the market efficiency hypothesis to be the simple statement that security prices fully reflect all available information. A precondition for this strong version of the hypothesis is that information and trading costs, the costs of getting prices to reflect information, are always 0 (Grossman and Stiglitz (1980)). A weaker and economically more sensible version of the efficiency hypothesis says that prices reflect information to the point where the marginal benefits of acting on information (the profits to be made) do not exceed marginal costs (Jensen (1978)).’
Fama (1991)
“Market efficiency is a description of how prices in competitive markets respond to new information. The arrival of new information to a competitive market can be likened to the arrival of a lamb chop to a school of flesh-eating piranha, where investors are - plausibly enough - the piranha. The instant the lamb chop hits the water, there is turmoil as the fish devour the meat. Very soon the meat is gone, leaving only the worthless bone behind, and the water returns to normal. Similarly, when new information reaches a competitive market there is much turmoil as investors buy and sell securities in response to the news, causing prices to change. Once prices adjust, all that is left of the information is the worthless bone. No amount of gnawing on the bone will yield any more meat, and no further study of old information will yield any more valuable intelligence.”
Robert C. Higgins, Analysis for Financial Management (3rd edition 1992)
‘A capital market is said to be efficient if it fully and correctly reflects all relevant information in determining security prices. Formally, the market is said to be efficient with respect to some information set, φ, if security prices would be unaffected by revealing that information to all participants. Moreover, efficiency with respect to an information set, φ, implies that it is impossible to make economic profits by trading on the basis of φ.’
Malkiel (1992)
‘...market efficiency (the hypothesis that prices fully reflect available information)...’
‘...the simple market efficiency story; that is, the expected value of abnormal returns is zero, but chance generates deviations from zero (anomalies) in both directions.’
Fama (1998)
‘A market is efficient with respect to the information set, Ωt, search technologies, St, and forecasting models, Mt, if it is impossible to make economic profits by trading on the basis of signals produced from a forecasting model in Mt defined over predictor variables in the information set Ωt and selected using a search technology in St.’
Timmermann and Granger (2004)

Others have argued that because information costs money, markets can never be efficient. This assertion is bolstered from academic corner by choas theorists who have analyzed market returns and found that they contain a feature know as persistency that is inconsistent with Efficient Market Hypothesis or more specifically, its cousin, the random walk. Markets are "marginally" efficient. What this mean to us traders is that the trends that see and trade every day are “real”. (I'm syre we all feel better now knowing that) In general, tomorrow's returns are weakly correlated with todays returns.

In spite of its questionable applicability to real (as apposed to hypothetical) markets, the efficient market hypothesis is not going anywhere soon because it supports one of Wallstreet's favorite myths: buy-and-hold.