The Efficient Market Hypothesis: Are You a Believer?

The efficient market hypothesis assumes that reasonable investors will set reasonable prices for investments based on known information. The hypothesis basically means, left to their own device, the markets would set fair values and prices on their own. The idea was first laid out by Louis Bachelier, a French mathematician. Bachelier's hypothesis is now called the weak hypothesis as newer applications have developed.

Weak, Semi-Strong and Strong Hypothesis

The weak hypothesis first described in 1900 states that the market responds to public information that has been set out prior to the trading day. Basically, the idea is all investors have a glimpse at all public information from the past on a potential investment, and they use this information to set a fair market price. At a later time, the semi-strong hypothesis was developed. This took the original one step further, saying that current public information on a stock was also used when investors reasonably considered whether to buy or sell. Eventually, the strong hypothesis evolved from this idea. The strong hypothesis is by far the most controversial and debatable. It asserts that the markets show not only public information but also reflect insider and private information about a stock or company. The belief is the individuals who have this information cannot protect it from leaking by showing their behavior, ultimately making private information public by observable changes in the trading of the underlying asset.

Influence Over Investments

In general, if the argument is to hold true, then the effect of the efficient market idea is constantly observable and constantly influencing the markets as a whole. If left to their own devices, investors would appropriately evaluate the value of a stock, bond or portfolio on a daily basis. This hypothesis can be used to explain why, in general, profitable investments are valued at a higher price than investments that are not as profitable. It can also explain why a company with poor performance may see challenges in gaining financing through performance stocks. The efficient market hypothesis is observable anytime the market reacts in a reasonable manner regarding the trading of a security.

Arguments Against the Hypothesis

Despite some observations that point toward accuracy in this model, there are a number of arguments against the hypothesis. One argument points to the popularity of constant growth stocks, over undervalued stocks. Constant growth stocks are those that have shown good returns in the past and promise good returns in the future. While they may be a sound investment, the market has already priced them at a fair value or even a high value. On the other hand, value stocks are those that are actually priced under the foreseeable profits they will produce. In an efficient market, investors would increase the demand for these stocks, eventually raising the price to a fair market level. Another argument to the contrary of the hypothesis is the actions of investors in a speculation or crash. In a speculation bubble, investors are not using the information at hand to make a sound decision. In a crash, investors may continue to sell stock even though it has returned to a fair market value.

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