Efficient Market Hypothesis 

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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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