The Efficient Markets Hypothesis

Nov 6, 2006 by

The Efficients Market Hypothesis states that financial markets are efficient, and that the prices of traded assets reflects all known information.

In its weak form, historical prices and financial data is included in the calculation made by the market when determining the current price. Thus, there is no excess returns can be made by looking at historical data. For instance, if I stated that you should buy XYZ because it has been going up for the last year, the statement would be of little value. Everyone knows that XYZ has been going up for the last year, and can see that. The information has been included in the price of the stock if most of the people in the market think it is true. If everyone thinks that it is going to jump from its price of $10/share last week to $20/share next month, buyers on the market will bid up the stock until it reaches $20/share. This bidding-up process occurs almost instantaneously in an efficient market with lots of buyers and sellers. Prices reflect all historical information.

In the semi-strong form of the Efficient Markets Hypothesis, prices take a small but non-zero amount of time to adjust to changes in the available public information. When something happens, like a disaster, it takes a few minutes for all of the traders on the market to know about it, and for the price to reflect that knowledge, even when it is public. Thus, there can be very short periods in which it is possible to earn excess returns. Prices reflect public information, but not private information.

In the strong form of the efficient markets hypothesis, all public and all private information is included in the pricing of assets. The assumption is that people with insider information will trade assets to the point that their information is reflected in the price. It should be noted that such insider trading is illegal in the United States, making the strong form of the Efficient Markets Hypothesis theoretically unlikely to occur. However, there is scientific evidence that people do trade on inside information within the U.S. Price reflects both public and private information.

So, on the eve of the election, what does this mean? Stock prices already account for the risk associated with all possible electoral outcomes. However, once results become known, prices in the market will rapidly begin shifting to reflect the new certainties. People who have inside information on the outcome of the election may be able to make a profit if they are able to discern what that outcome means for the market, and trade on the information before prices account for it. By the time the markets open on Wednesday and all the results are known, the prices on the market will fully reflect the election’s outcomes. What does this mean for me? I have chosen not to hold IYY on the eve of the election, as I do not know what will happen to it on Wednesday. According to the Efficient Markets Hypothesis, the past month of performance should have no bearing on the next week’s performance. Once the market accounts for the election’s outcome (with either a higher or a lower price for the Dow), things will stabilize, and then continue on their natural course, incorporating the new information.

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1 Comment

  1. The trouble with EMH in any form is that it is your typical economic “model” – it is an abstraction based on ideal behaviour, not the real world. Take for example a small company that only trades a few thousand shares each day. Each buy and sell price will probably have been set by a small investor, based on limited knowledge and limited experience. It does not matter if all relevant information is in the public domain – most of it won’t have been used by the market participants who are placing the buy and sell orders. Similarly, there are many situations where even large, professional investors won’t be trading at prices that reflect all the public information – for example, if a share drops out of an index, many fund managers will have to sell regardless of what price an analysis of the public information available about the company would indicate is fair value.

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