In the 1960s, Eugene F. Fama and Paul A. Samuelson independently suggested the efficient market hypothesis (EMH). This theory implies that all available information is already reflected in stock prices. Therefore, it is impossible for any investor in the long term to get returns substantially higher than the market average. In other words, a lucky investor may outperform the market in the short term, but it is impossible in the long run.
The efficient market hypothesis also assumes that there is no arbitrage opportunity, i.e., stocks are always traded in the market at their current fair value. In other words, it is impossible for any investor to earn arbitrage profit from buying undervalued stocks or selling overvalued stocks.
The efficient market hypothesis only holds if the following assumptions are met:
Although the proposed theory has not been refuted, the assumptions have come under serious criticism.
In the real world, investors do not have equal access to all available information. Some of the information always remains private. Persons who have access to private information are called insiders. Examples of insiders can be top managers and government and central bank officials. All these people have access to information that is not available to the general public. Although insider trading is prosecuted, such persons have an advantage over other market investors. The availability of arbitrage opportunity ruins the assumptions on which the efficient market hypothesis is based.
It is obvious that an efficient market cannot exist in the real world. This was the reason why the theory was further developed by highlighting the three forms of market efficiency: weak, semistrong, and strong. All of them differ in the degree of availability of information for investors.
The weak form of market efficiency implies that investors have equal access to information about all historical stock prices. In turn, this information has already been reflected in stock prices. As a consequence, price movements in the past do not give any clue for investors of their movement in the future. In other words, technical analysis becomes useless, as it is impossible to earn extra profit from trading strategy based on historical information.
Semistrong efficiency assumes that stock prices reflect not only historical stock price information but also all publicly available information. Since all investors simultaneously receive publicly available information, none of them will be able to earn extra profit.
The semistrong form of market efficiency designates that some information still remains private. Persons who get access to it are called insiders (e.g., chief executive officer, top management, board of directors). Using their advantage, they are able to earn a much higher return than the market average.
Strong efficiency is based on the same assumptions as efficient market hypothesis. Stock prices reflect all available public and private information, so any investor is not able to outperform the market average in the long run.
Many empirical studies have tried to confirm or disprove the efficient market hypothesis, but the theory remains a subject of discussion. It is quite obvious that a strong form of market efficiency is not inherent in real capital markets. This can be illustrated by the example of market reaction to “good news”.
If real capital markets were really efficient, change in the stock price would occur immediately, but this situation does not exist in the real world, since real capital markets show either overreaction or delayed response to the news, which is illustrated in the graph above.
Summarizing the above, we can conclude that real capital markets may be efficient to some extent, but the efficient market hypothesis is not entirely reliable.