Per Wikipedia (link), the efficient market hypothesis (EMH) is defined as:
..the efficient-market hypothesis (EMH) asserts that financial markets are “informationally efficient”. That is, one cannot consistently achieve returns in excess of average market returns on a risk-adjusted basis, given the information available at the time the investment is made.
There are three major versions of the hypothesis: “weak”, “semi-strong”, and “strong”. The weak-form EMH claims that prices on traded assets (e.g.,stocks, bonds, or property) already reflect all past publicly available information. The semi-strong-form EMH claims both that prices reflect all publicly available information and that prices instantly change to reflect new public information. The strong-form EMH additionally claims that prices instantly reflect even hidden or “insider” information. There is evidence for and against the weak-form and semi-strong-form EMHs, while there is evidence against strong-form EMH.
As mentioned earlier in our posts here and here that the markets are not efficient, actually, they are highly inefficient. The market fails to adjust the stock price to the correct price. Now that comes with a corollary, that individual investors CAN find the right investment, and achieve consistent higher returns that the market.
However to achieve higher returns than the market, one needs to grasp the long-term horizon and focus away from the short-term market risk, aka volatility in the stock prices. A prudent investor understands that this notion of risk fades away in the long-term as the only risk that does matter in the long-term is the soundness of the business and operations you are investing in.
Another corollary from inefficient market hypothesis is that an investor just cannot pick random stocks from the index and achieve the average return of the stock market, and it would be rather foolish to take such approach. Common sense investing necessitates that the investor must investigate the operations and soundness of the business by thoroughly analyzing the balance sheet and the income statement.
THE DEGREE OF MARKET EFFICIECNY/ INEFFICIENCY
A Look at Academic and Professional Research
by Hassan Adil
There is abundant amount of research done on the efficiency of the markets. However, the academics and professionals have yet to come to a conclusion about the degree of efficiency. This study will contribute to the understanding of the efficient market hypothesis, as first proposed by Fama. Later the paper will discuss the weak form, semi-strong, and briefly, the strong form of the market efficiency. This paper will synthesize academic research spanning from the 1960’s to 2010 regarding market efficiency. Finally this still will also provide a conclusion regarding the degree of the market efficiency after weighing and discussing the research conducted so far about the efficiency of the markets.
For the full text, continue to the article.
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There are a few topics that I remember discussing as a student with my professors in Finance class, however most of the time we would discuss the efficiency of the markets, the CAPM model, the risk-free asset and how the last 40 years have changed so much, much thanks to Fama and his breakthrough research paper on the Efficiency of Markets (refer to the attached pdf on a paper re: the above topic).
In my Masters thesis paper I got the opportunity to really discuss the efficiency of the markets, as mentioned by Fama. However, looking back it seems that the efficiency of the market is not always true. It may be true during certain instances, for example during the boom years, however it is certainly not true when there is a financial crisis. The logic is simple; if the market was really efficient, and it readily absorbed all of the information, and came to a valid AND true conclusion regarding the price of a particular security, then there would be no bubbles. Certainly we know that is not true.
Welcome to the real world, dear Finance Students.
Theory: What you learn at school may not be applicable in real life.
Lemma: Having more degrees does not make you more knowledge and/or expert in your field.
Corollary: You just wasted 4 years of life, or more.
Welcome to layman’s finance.