The Efficient Markets Hypothesis
by MaestriA body of theory called the Efficient Markets Hypothesis (EMH) holds (1) that stocks are always in equilibrium and (2) that it is impossible for an investor to consistently “beat the market.” Essentially, those who believe in the EMH note that there are 100,000 or so full-time, highly trained, professional analysts and traders operating in the market, while there are fewer than 3,000 major stocks. Therefore, if each analystfollowed 30 stocks (which is about right, as analysts tend to specialize in the stocks in a specific industry), there would on average be 1,000 analysts following each stock. Further, these analysts work for organizations such as Citibank, Merrill Lynch, Prudential Insurance, and the like, which have billions of dollars available with which to take advantage of bargains. In addition, as a result of SEC disclosure requirements and electronic information networks, as new information about a stock becomes available, these 1,000 analysts generally receive and evaluate it at about the same time. Therefore, the price of a stock will adjust almost immediately to any new development.
Levels of Market Efficiency
If markets are efficient, stock prices will rapidly reflect all available information. This raises an important question: What types of information are available and, therefore, incorporated into stock prices? Financial theorists have discussed three forms, or levels, of market efficiency.
Weak-Form Efficiency The weak form of the EM states that all information contained in past price movements is fully reflected in current market prices. If this were true, then information about recent trends in stock prices would be of no use in selecting stocks—the fact that a stock has risen for the past three days, for example, mean that new developments could not cause a stock’s price to soar or to plummet, but
it does mean that stocks in general neither overvalued nor undervalued—they are fairly priced and in equilibrium. However, there are certainly cases in which corporate insiders have information not known to outsiders.
If the EMH is correct, it is a waste of time for most of us to analyze stocks by looking for those that are undervalued. If stock prices already reflect all publicly available information, and hence are fairly priced, one can “beat the market” consistently only by luck, and it is difficult, if not impossible, for anyone to consistently outperform the market averages. Empirical tests have shown that the EMH is, in its weak and semistrong forms, valid. However, people such as corporate officers, who have inside information, can do better than the averages, and individuals and organizations that are especially good at digging out information on small, new companies also seem to do consistently well. Also, some investors may be able to analyze and react more quickly than others to releases of new information, and these investors may have an advantage over others.
Taken From : Five-Minute MBA – Corporate Finance
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