An Argument against the Efficient Market Hypothesis

The efficient market hypothesis was first developed by French mathematician Louis Bachelier in 1900. He asserted that, generally speaking, the price of a stock reflects the public information available on that stock at a given time. According to this hypothesis, because investors know the available public information, they will determine the most efficient price based on that information in a simple supply and demand model. While the model may hold true in an educated investor pool, the fact that many investors lack the background and reasoning needed to properly analyze public information generally makes this model unreliable. 

Versions of the Efficient Market Hypothesis

There are many levels of the efficient market hypothesis. The broadest version, called the weak efficient market hypothesis, states that prices reflect past information about the company. This is not as highly criticized as the semi-strong version, which asserts that current information is also reflected in price. Finally, the strong hypothesis asserts that even insider information can be reflected in price and that the ultimate price of a stock at a given time relies on more than public information. The final version is the most criticized.

Valuable Stocks vs. Growth Stocks

One argument against the efficient market hypothesis is the fact that most investors tend to purchase growth stocks instead of stocks trading under their value. Growth stocks are those that have shown success in the past, providing consistent returns, but are offered at a price either consistent with or even over their actual value. These are widely popular despite public information that would lead many to believe there are better deals on the market. These "deals" are value stocks, those whose public information reflects the fact that a price should be higher than what the current trading price actually is. Investors, if they were acting rationally according to the efficient market hypothesis, would buy these up, raising the price.

Bubbles and Speculation

Instead of raising the price of undervalued stocks, though, the market often creates bubbles due to speculation in an irrational fashion. There is often a public overreaction to some initial positive information, as was seen during the dot-com bubble in the early 2000s. While the value of the underlying assets did not support the then-current prices, investors still purchased the stocks, driving the prices even higher than the underlying factors would indicate was wise. This type of irrational behavior typically leads to frantic selling later on, even when the prices have realigned with value.

Market Crashes

Frantic selling can lead to a market crash, which is another problem with the efficient market hypothesis. Some selling would make sense, bringing the price of an asset back in line with its actual value. In the case of a crash, though, investors continue to sell off assets even when the price is fair, and indications would point to the fact that holding the asset is a wise idea. This irrational behavior is associated with market panic, which is often reported as groupthink, or the tendency to be influenced by the actions of others. Psychologists studying groupthink's effect on the market present it is a sufficient barrier to the efficient market hypothesis.

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