The efficient market hypothesis suggests that asset prices reflect all available information from "summary" of International Financial Management, Abridged Edition by Jeff Madura
The efficient market hypothesis asserts that asset prices fully incorporate all information that is available to the public. This implies that it is impossible for investors to consistently achieve above-average returns by analyzing publicly available information. If this hypothesis holds true, it suggests that stock prices adjust rapidly to any new information that becomes available, making it difficult for investors to exploit any information asymmetries for profit. The efficient market hypothesis comes in three forms: weak, semi-strong, and strong. In the weak form, asset prices reflect all past trading information, such as historical prices and trading volumes. This implies that technical analysis, which involves studying past price movements to predict future price movements, is unlikely to yield above-average returns. In the semi-strong form, asset prices incorporate all publicly available information, including not only past trading data but also information on financial statements, economic indicators, and news reports. Lastly, the strong form of the efficient market hypothesis posits that asset prices reflect all information, including both public and private information. This means that even insiders with privileged information cannot consistently outperform the market. The efficient market hypothesis has important implications for investors and financial managers. For investors, it suggests that it is challenging to beat the market consistently through stock picking or market timing. Instead, investors may choose to adopt a passive investment strategy, such as investing in index funds that track the overall market. For financial managers, the efficient market hypothesis implies that it is difficult to generate excess returns through active portfolio management. Instead, financial managers may focus on minimizing costs and risks through diversification and asset allocation. Critics of the efficient market hypothesis argue that markets are not always perfectly efficient. They point to anomalies, such as stock price bubbles and crashes, as evidence that asset prices can deviate from their intrinsic values. Some researchers have also found evidence of predictability in asset prices, challenging the notion that markets fully incorporate all available information. Despite these criticisms, the efficient market hypothesis remains a foundational concept in finance and has influenced the development of modern portfolio theory and other investment strategies.
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