
Efficient Market Hypothesis
The efficient market hypothesis states that security prices reflect all
available information and adjust instantly to any new information.
Stocks are always correctly priced, making it impossible for
investors to outperform the stock market averages except by buying
more risky securities. The basic premise of the efficient market
hypothesis is that stock markets are efficient in the pricing of stocks
because information about the stocks is rapidly disseminated
throughout the investment community. Thus, if investors and
analysts use the same public information about stocks, generating
superior returns is difficult because the rest of the investment
community has the same information. The stock’s price then
reflects all available information, which implies that few stocks are
mispriced. If a stock is undervalued, investors quickly buy it,
which drives up the price to its fair value and reduces returns
for subsequent investors. Similarly, overvalued stocks are sold,
which reduces the price to its fair value. In other words, stocks
are not mispriced for long. Stocks settle at their intrinsic values,
which reflect the investment community’s consensus about their
earnings, returns and risks.
The implication of efficient markets is that investors cannot
expect to consistently outperform the markets or consistently
underperform the markets on a risk-adjusted basis. On average,
investors will do no better or no worse than the market averages
over an extended period of time with a diversified portfolio of
stocks. This statement does not mean that investors cannot find
securities that earn abnormally high returns. For example, if you
had bought Oracle Corporation’s stock at $12 per share in October
2005 and held it for a year, you would have earned a 58 percent
return as compared with a 17 percent return for the DJIA and a
16 percent return for the Standard & Poor’s (S&P) 500 Index. The
theory of efficient markets implies that investors cannot consistently
buy stocks such as Oracle, for example, to earn abnormally
high returns over long periods.
The question that is asked most often about the efficient market
hypothesis is, “What is the degree of efficiency in the markets?”
Obviously, investors who believe that the markets are inefficient
will continue using different techniques and analyses to select
stocks that produce superior returns. However, if markets are efficient,
the value of these techniques and analyses is diminished. The
implication from both fundamental analysis and technical analysis
theories is that the markets are inefficient. By investing in stocks
with low price/earnings (P/E) ratios or high earnings yields or by
purchasing stocks at the low end of their trading ranges, investors
expect to receive higher returns. This situation may occur; but
according to the efficient market hypothesis, investors cannot
consistently outperform the markets by earning abnormally large
returns on a risk-adjusted basis.
Considerable debate takes place in academic circles about the
degree of efficiency in the markets, centered on three forms of the
efficient market hypothesis:
* Weak form
* Semistrong form
* Strong form
The degree of market efficiency has important ramifications for
investors and the strategies chosen for the selection of their stocks.
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