The Efficient Markets Hypothesis

The efficient markets hypothesis claims financial and industry markets quickly incorporate economic conditions, and market forces into the prices of financial instruments, an example of which are stocks. In an efficient market, financial strengths and weaknesses are quickly discovered, and then rectified via adjusted pricing.

Financial specialists are often quoted as "It's impossible to find a $20.00 bill lying on the ground for very long." In other words, if there is money to be found, it won't last long because the markets are efficient at finding money. The efficient markets hypothesis is essentially comprised of the same underlying principle, i.e. financial markets are adept and quick at finding value therefore value, whether it be high or low, quickly becomes adjusted for through financial product pricing mechanism.

• How the efficient markets hypothesis works

Market efficiency is based on 1) History and 2) Information, both of which are key determinants of price at any given time within a products pricing.(1) For example, if apples are most plentiful in the later summer and fall, there availability is more likely to be plentiful during these seasons, potentially driving the supply of apples up and the price down.

In the later winter and spring the opposite may be true. Over time a pattern emerges and the prices adjust automatically based on historical information making the market efficient.

Another factor that leads to efficiency is information. Using the example above, suppose a major bug infestation that damages Apples grown in a major apple growing region occurs. Market efficiency claims the information about the information will quickly spread throughout the network of agriculturalists, and markets thereby affecting price accordingly and that all prices include relevant information regarding a commodity or product.

• What market efficiency means for businesses and consumers

Since markets are efficient according the efficient market hypothesis, then 1) prices are always if not mostly reflective of current events, information and historical patterns, and 2) due to this efficiency, outperforming the market over time in terms of pricing, cannot be achieved since businesses cannot be more efficient than the market as a whole.

While there is some truth to the claims of market efficiency it not entirely factual as some mutual funds, hedge funds and investment managers have outperformed the markets over time. Historical performance does indicate that some, not all, mutual funds do outperform the markets, as measured by indices, over time.

To explain further, according to an excerpt from the book "Common Send on Mutual Funds: New Imperatives for the Intelligent Investor", only 6 of 258 mutual funds studied consistently outperformed market efficiency over time.(2) This is a small minority but does seem to indicate market efficiency is not 100 percent efficient.

• Evidence supporting the efficient markets hypothesis

The efficient markets hypothesis has been quantitatively and statistically tested numerous times in different markets and the findings have been quite consistent. Specifically, efficiency tests such as those referenced in this article demonstrate "weak form efficiency" i.e. market efficiency based on historical price patterns, is consistently evident whereas "strong form efficiency" i.e. market efficiency based on current information is also moderately evident and consistent.(3)

Other evidence that has claimed the validity of market efficiency is made evident in the research of Garcia, Sangiorgi and Urosevic, and published through the University of Geneva.(4) The conclusions of these researchers found market efficiency to be the result of a balance of investments decisions made by 'heterogeneous agents' i.e. diversified levels of rationale among investors.

Summary

What the efficient markets hypothesis means is "markets" be they financial markets, commodities markets, retail or otherwise quickly adjust prices of goods and/or services to account for changes in cost of goods sold, value, appreciation, depreciation, historical trends etc. These adjustments occur rapidly according to the market efficiency hypothesis and are more likely to occur quickly in cases of historical patterns than sudden information regarding a product or service.

The efficient markets hypothesis does have statistical validity as prices can and do frequently adjust to changes affecting the economy and profitability of a product or service. This is further evidenced by the performance of mutual funds over time according to the above quoted study. Nevertheless and despite the strong evidence supporting market efficiency, the market is probably not 100% efficient as there are documented cases of investors, fund managers and financial institutions that are able to "beat the market" however few and far between they may be.

Sources:

1. http://bit.ly/a1EXP9   (Investopedia)
2. http://yhoo.it/c3qJnB (Yahoo Finance)
3. http://bit.ly/94HaWO (Alvinhan.com)
4. http://bit.ly/b8Pnii      (Wikipedia)
5. http://bit.ly/9hvCne    (University of Geneva)