Efficient-market hypothesis EMH is a theory in financial economics that states that an asset 's prices fully reflect all available information. A direct implication is that it is impossible to "beat the market" consistently on a risk-adjusted basis since market prices should only react to new information or changes in discount rates the latter may be predictable or unpredictable.

The EMH was developed by Professor Eugene Fama who argued that stocks always trade at their fair value, making it impossible for investors to either purchase undervalued stocks or sell stocks for inflated prices. As such, it should be impossible to outperform the overall market through expert stock selection or market timing, and that the only way an investor can possibly obtain higher returns is by chance or by purchasing riskier investments.

There are three variants of the hypothesis: The weak form of the EMH claims that prices on traded assets e. The semi-strong form of the EMH claims both that prices reflect all publicly available information and that prices instantly change to reflect new public information.

The strong form of the EMH additionally claims that prices instantly reflect even hidden "insider" information. Critics have blamed the belief in rational markets for much of the lates financial crisis. Historically, the EMH is preceded by Hayek's argument that markets are the most effective way of aggregating the pieces of information dispersed amongst individuals within a society.

Given the ability to profit from private information, self-interested traders are motivated to acquire and act on their private information. In doing so, traders contribute to more and more efficient market prices. In the competitive limit, market prices reflect all available information and prices can only move in response to news. Thus there is a very close link between EMH and the random walk hypothesis which was discussed in by Jules Regnaulta French broker. Later another French mathematician, Louis Bachelierapplied probability theory in his PhD thesis, "The Theory of Speculation.

Empirically, a number of studies indicated that US stock prices and related financial series followed a random walk model in the short-term. Research by Alfred Cowles in the s and s suggested that professional investors were in general unable to outperform the market.

While event studies of stock splits is consistent with the EMH Fama, Fisher, Jensen, and Roll,other empirical analyses have found problems with the efficient-market hypothesis. Early examples include the observation that small neglected stocks and stocks with low book-market ratios value stocks tended to achieve abnormally high returns relative to what could be explained by the CAPM. Following GJR's results and mounting empirical evidence of EMH anomalies, academics began to move away from the CAPM towards risk factor models such as the Fama-French 3 factor model.

It should be noted that these risk factor models are not properly founded on economic theory whereas CAPM is founded on Modern Portfolio Theorybut rather, constructed with long-short portfolios in response to the observed empirical EMH anomalies. For instance, the "small-minus-big" SMB factor in the FF3 factor model is simply a portfolio that holds long positions on small stocks and short positions on large stocks to mimic the risks small stocks face. These risk factors are said to represent some aspect or dimension of undiversifiable systematic risk which should be compensated with higher expected returns.

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Additional popular risk factors include the "HML" value factor Fama and French, ; "MOM" momentum factor Carhart, ; "ILLIQ" liquidity factors Amihud et al. When testing the EMH one inevitably finds that 1 either the market is inefficient, or 2 the asset pricing model used to test market efficiency is incorrect. Hence tests of market efficiency run into this joint hypothesis problem.

For instance, early tests of market efficiency used the CAPM, which could be an incomplete model of asset prices; test results on market efficiency would thus be inconclusive.

Formally, the joint hypothesis problem says that it is never possible to test sufficiently, to prove or disprove market efficiency. A test of market efficiency must include some model for how prices may be set efficiently. Then actual prices can be examined to see whether this holds true. Usually this fails and then this supports the case that markets are not efficient. The joint hypothesis problem says that, when this happens, it shows that the model is not complete.

There are some factors that are not accounted for. The efficient-market hypothesis emerged as a prominent theory in the mids. Paul Samuelson had begun to circulate Bachelier's work among economists. In Bachelier's dissertation along with the empirical studies mentioned above were published in an anthology edited by Paul Cootner. The paper extended and refined the theory, included the definitions for three forms of financial market efficiency: It has been argued that the stock market is "micro efficient" but not "macro efficient".

The main proponent of this view was Samuelson, who asserted that the EMH is much better suited for individual stocks than it is for the aggregate stock market. Research based on regression and scatter diagrams has strongly supported Samuelson's dictum. Further to this evidence that the UK stock market is weak-form efficient, other studies of capital markets have pointed toward their being semi-strong-form efficient.

A study by Khan of the grain futures market indicated semi-strong form efficiency following the release of large trader position information Khan, Studies by Firth, and in the United Kingdom have compared the share prices existing after a takeover announcement with the bid offer.

Firth found that the share prices were fully and instantaneously adjusted to their correct levels, thus concluding that the UK stock market was semi-strong-form efficient. However, the market's ability to efficiently respond to a short term, widely publicized event such as a takeover announcement does not necessarily prove market efficiency related to other more long term, amorphous factors. David Dreman has criticized the evidence provided by this instant "efficient" response, pointing out that an immediate response is not necessarily efficient, and that the long-term performance of the stock in response to certain movements are better indications.

Beyond the normal utility maximizing agents, the efficient-market hypothesis requires that agents have rational expectations ; that on average the population is correct even if no one person is and whenever new relevant information appears, the agents update their expectations appropriately.

Note that it is not required that the agents be rational. EMH allows that when faced with new information, some investors may overreact and some may underreact. All that is required by the EMH is that investors' reactions be random and follow a normal distribution pattern so that the net effect on market prices cannot be reliably exploited to make an abnormal profit, especially when considering transaction costs including commissions and spreads.

Thus, any one person can be wrong about the market—indeed, everyone can be—but the market as a whole is always right.

There are three common forms in which the efficient-market hypothesis is commonly stated— weak-form efficiencysemi-strong-form efficiency and strong-form efficiencyeach of which has different implications for how markets work. In weak-form efficiency, future prices cannot be predicted by analyzing prices from the past. Excess returns cannot be earned in the long run by using investment strategies based on historical share prices or other historical data.

Technical analysis techniques will not be able to consistently produce excess returns, though some forms of fundamental analysis may still provide excess returns.

Share prices exhibit no serial dependencies, meaning that there are no "patterns" to asset prices. This implies that future price movements are determined entirely by information not contained in the price series. Hence, prices must follow a random walk. This 'soft' EMH does not require that prices remain at or near equilibrium, but only that market participants not be able to systematically profit from market ' inefficiencies '. However, while EMH predicts that all price movement in the absence of change in fundamental information is random i.

There is a vast literature in academic finance dealing with the momentum effect identified by Jegadeesh and Titman. The momentum strategy is long recent winners and shorts recent losers, and produces positive risk-adjusted average returns.

Being simply based on past stock returns, the momentum effect produces strong evidence against weak-form market efficiency, and has been observed in the stock returns of most countries, in industry returns, and in national equity market indices.

Moreover, Fama has accepted that momentum is the premier anomaly [25] [26]. The problem of algorithmically constructing prices which reflect all available information has been studied extensively in the field of computer science.

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A novel approach for testing the weak form of the Efficient Market Hypothesis is using quantifers derived from Information Theory. In this line, Zunino et al. Using a similar technique, Bariviera et al.

The methodology forex bhutan by econophysicists Zunino, Bariviera and coauthors is new and alternative to usual econometric techniques, and is able to detect changes in the stochastic and or chaotic underlying dynamics of prices time series.

In semi-strong-form efficiency, it is implied that share prices adjust to publicly available new information very rapidly and in an unbiased fashion, such that no excess returns can be earned by trading on that information.

Semi-strong-form efficiency implies that neither fundamental analysis nor technical analysis techniques will be able to reliably produce excess returns. To test for semi-strong-form efficiency, the adjustments to previously unknown news must be of a reasonable size and must be instantaneous.

To test for this, consistent upward or downward adjustments after the initial change must be looked for. If there are any such adjustments it would suggest that investors had interpreted the information in a biased fashion and hence in an inefficient manner.

In strong-form efficiency, share prices reflect all information, public and private, and no one can earn excess returns.

If there are legal barriers to private information becoming public, as with insider trading laws, strong-form efficiency is impossible, except in the case where the laws are universally ignored. To test for strong-form efficiency, a market needs to exist where investors cannot consistently earn excess 30 pips per day forex over a long period of time.

Even if some money managers are consistently observed to beat the market, no refutation even of strong-form efficiency follows: Investors, including the likes of Warren Buffettdescribe how speculation in the stock market contributed to the great depression and researchers have disputed the efficient-market hypothesis both empirically and theoretically.

Behavioral economists attribute the imperfections in financial markets to a combination of cognitive biases such as overconfidenceoverreaction, representative bias, information biasand various other predictable human errors in reasoning and information processing. These have been researched by psychologists such as Daniel KahnemanAmos TverskyRichard Thalerand Paul Slovic.

These errors in reasoning lead most investors to avoid value stocks and buy growth stocks at expensive prices, which allow those who reason correctly to profit from bargains in neglected value stocks and the overreacted selling of growth stocks. One can identify "losers" as stocks that have had poor returns over some number of past years.

The main result of one such study is that losers have much higher average returns than winners over the following period of the same high success forex strategy of years. Losers would have to have much higher betas than winners in order to justify the return difference.

The study showed that the beta difference required to save the EMH is just not there. It is important to note, however, that these studies were compiled in the mids and may not be reflective of more modern trends of efficiency, which often 5 minute binary options system one touch strategy around extensive internet and computer based information analytics.

These bubbles are typically followed by an overreaction of frantic selling, allowing shrewd investors to buy stocks at bargain prices. Rational investors have difficulty profiting by shorting irrational bubbles because, in the words of a famous saying attributed to John Maynard Keynes"Markets can stay irrational longer than you can stay solvent. Benoit Mandelbrot stock market floor hand signals argued that market bubbles are not anomalous stock market floor hand signals rather characteristic of price dynamics described by power laws such as Pareto, Zipf [42] or Tracy-Widom [43] combined with persistence in price change trends.

Burton Malkiel has warned that certain emerging markets such as China are not empirically efficient; that the Shanghai and Shenzhen markets, unlike markets in United States, exhibit considerable serial correlation price trendsnon-random walk, and evidence of manipulation.

Behavioral psychology approaches to stock market trading are among some of the more promising [ citation needed ] alternatives to EMH and some [ which? But Nobel Laureate co-founder of the programme Daniel Kahneman —announced his skepticism of investors beating the market: It's just not going to happen.

For example, one prominent finding in Behaviorial Finance is that individuals employ hyperbolic discounting. It is demonstrably true that bondsmortgagesannuities and other similar financial instruments subject to competitive market forces do not.

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Any manifestation of hyperbolic discounting in the pricing of these obligations would invite arbitrage thereby quickly eliminating any vestige of individual biases. Similarly, diversificationderivative securities and other hedging strategies assuage if not eliminate potential mispricings from the severe risk-intolerance loss aversion of individuals underscored by behavioral finance. On the other hand, economists, behaviorial psychologists and mutual fund managers are drawn is it easy to make money on scottrade the human population and are therefore subject to the biases that behavioralists showcase.

By contrast, the price signals in markets are far less subject to individual biases highlighted by the Behavioral Finance programme. Richard Thaler has started a fund based on his research on cognitive biases. In a report he identified complexity and herd behavior as central to the global financial crisis of Further empirical work has highlighted the impact transaction costs have on the concept of market efficiency, with much evidence suggesting that any anomalies pertaining to market inefficiencies are the result of a cost benefit analysis made by those willing to incur the cost of acquiring the valuable information in order to trade on it.

Additionally the concept of liquidity is a critical component to capturing "inefficiencies" in tests for abnormal returns. Any test of this proposition faces the joint hypothesis problem, where it is impossible to ever test for market efficiency, since to do so requires the use of a measuring stick against which abnormal returns are compared —one cannot know if the market is efficient if one does not know if a model correctly stipulates the required rate of return.

Consequently, a situation arises where either the asset do at home cholesterol tests work model is incorrect or the market is inefficient, but one has no way of knowing which is the case.

The performance of stock markets is correlated with the amount of sunshine in the city where the main exchange is located. A key work on random walk was done in the late s by Profs. Andrew Lo and Craig MacKinlay; they effectively argue that a random walk does not exist, nor ever has. In his book The Reformation in Economics the economist Philip Pilkington has argued that the EMH is actually a tautology masking as a theory [51].

He argues that the theory rests on the assertion that the average investor will not beat the market average. But this is obviously a flat tautology as the average investor will always track how to earn money by shorten url market average by construction.

When formulated with slightly more clarity the argument states that all investors will, over time, tend toward the average. According to Pilkington this claim is less tautological than the claim that the average investor will not beat the market average but has nevertheless been implicitly constructed in a similar manner.

In order to show this he cites the fact that EMH proponents will label anyone who beats the market over a period of time "lucky". But Pilkington points out that neither the EMH proponents nor anyone else have any criteria by which to distinguish luck from skill. This leads to the theory falling back into tautology. It states that all investors will tend back to the market average over time and those that do not conform to this are simply lucky. The final part of the argument is entirely arbitrary as "luck" cannot be proved and seems unlikely.

But this assertion of luckiness ensures that, by definition, no investor can fall outside the theory because if they do they are arbitrarily reassigned by the theory to be of no importance. Pilkington argues that this argument is a logical absurdity and could be applied to anyone skilled in their field. In order for the EMH bid ask spread currency exchange to make sense, [its proponents] would have to show that [the] small number of investors that beat the market in the long-run are not doing so because they are skilled but rather that they are lucky.

How would they show this? Frankly, it is impossible to prove either way. But it strikes me as a very silly argument. We could just as easily apply it to [highly skilled] poker players. We could say "Oh, they are not really skilled, they are just lucky. They are just a statistical anomaly. We could say this about professional football players, master chefs and seminal guitar players. None of these people, by EMH logic, should be seen as skilled.

Rather, they are just getting lucky over and over again. The professional football players are just getting lucky every time they play well; the master chef is getting lucky every time he cooks a fabulous meal; and the seminal guitar player is just fortunate that his hands move in the way that they do.

At this point, the reader will appreciate the vacuity of the EMH argument. Economists Matthew Bishop and Michael Green claim that full acceptance of the hypothesis goes against the thinking of Adam Smith and John Maynard Keyneswho both believed irrational behavior had a real impact on the markets.

Economist John Quiggin has claimed that " Bitcoin is perhaps the finest example of a pure bubble", and that it provides a conclusive refutation of EMH. Since Bitcoins do not generate any actual earnings, they must appreciate in value to ensure that people are willing to hold them. InKim Man Lui pointed out that there is difference of performance between experienced and novice traders in a controlled experiment.

If the market really walks randomly, there should be no difference between these two kinds of traders. However, traders who are more knowledgeable on technical analysis significantly outperform those who are less knowledgeable.

Tshilidzi Marwala surmised that artificial intelligence influences the applicability of the theory of the efficient market hypothesis in that the more artificial intelligence infused computer traders there are in the markets as traders the more efficient the markets become.

Warren Buffett has also argued against EMH, most notably in his presentation The Superinvestors of Graham-and-Doddsvillesaying the preponderance of value investors among the world's best money managers rebuts the claim of EMH proponents that luck is the reason some investors appear more successful than others.

The financial crisis of —08 led to renewed scrutiny and criticism of the hypothesis. At the International Organization of Securities Commissions annual conference, held in Junethe hypothesis took center stage. Martin Wolfthe chief economics commentator for the Financial Timesdismissed the hypothesis as being a useless way to examine how markets function in reality.

Paul McCulleymanaging director of PIMCOwas less extreme in his criticism, saying that the hypothesis had not failed, but was "seriously flawed" in its neglect of human nature.

The financial crisis led Richard Posnera prominent judge, University of Chicago law professor, and innovator in the field of Law and Economics, to back away from the hypothesis and express some degree of belief in Keynesian economics. Posner accused some of his Chicago School colleagues of being "asleep at the switch", saying that "the movement to deregulate the financial industry went too far by exaggerating the resilience—the self healing powers—of laissez-faire capitalism.

Despite this, Fama has conceded that "poorly informed investors could theoretically lead the market astray" and that stock prices could become "somewhat irrational" as a result. Critics have suggested that financial institutions and corporations have been able to reduce the efficiency of financial markets by creating private information and reducing the accuracy of conventional disclosures, and by developing new and complex products which are challenging for most market participants to evaluate and correctly price.

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The theory of efficient markets has been practically applied in the field of Securities Class Action Litigation. Efficient market theory, in conjunction with " Fraud on the Market Theory ," has been used in Securities Class Action Litigation to both justify and as mechanism for the calculation of damages.

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