Efficient market hypothesis: The long and short of it

Written by P Saravanan | Updated: Jun 10 2014, 14:25pm hrs
Investors are typically concerned about long-term performance when comparing alternative investments. So, the question is, over the long term, can investors beat market returns To answer this, we need to understand efficient market hypothesis (EMH) and its implication.

What is emh

An efficient capital market is one in which security prices adjust rapidly to new information and, so, the current price reflects all information about the security. This hypothesis suggests that only few investors will beat the average market return consistently over a long period. For instance, if the market advances 20% over one year, most investors will not earn more than 20%. In fact, most investors earn less than market average because of transaction costs and fees charged.

Why capital markets should be efficient

An important premise of an efficient market is that a large number of profit-maximising participants analyse and value securities, each independently of others. A second assumption is that new information regarding securities comes to the market randomly. The third assumption is, profit-maximising investors adjust security prices rapidly to reflect the effect of new information. Prices adjust rapidly as investors compete with each other.

So, what does this mean for individual investors, portfolio managers and institutions Lets consider the implications with reference to technical and fundamental analysis.

EMH & technical analysis

The assumptions of technical analysis oppose the efficient market notion. A basic premise of technical analysis is that stock prices move in trends that persist. Technical analysts believe that when new information comes to the market, it is not immediately available to everyone but typically disseminated from the informed professional to the aggressive investing public and then to the rest. So they hypothesise that stock prices move to a new equilibrium after the release of new information gradually. Technical analysts believe nimble traders can develop systems to detect the beginning of a movement to a new equilibrium (called breakout). They hope to buy or sell the stock immediately after its breakout.

EMH and fundamental analysis

Fundamental analysts believe that, at any time, there is an intrinsic value for the aggregate stock market, various industries and individual securities, and these depend on the underlying economic factors. So, investors should determine the intrinsic value of a security or asset by examining the variables that determine values, such as current and future earnings or cash flows. You buy if the market price is substantially below the intrinsic value and sell if it is above. If you can do a good job on estimating the intrinsic value, you can consistently make high returns by acquiring undervalued securities and generating above-average returns. Fundamental analysis involves aggregate market analysis, industry analysis, company analysis and portfolio management.

EMH is debated among academicians and incongruence exists on the degree of market efficiency. Even though the hypothesis has not aroused the enthusiasm of investors, the implications are major they shatter any illusions of creating wealth overnight.