Efficient Market Hypothesis: Is The Stock Market Efficient?

An important debate among stock market investors is whether the market
is efficient - that is, whether it reflects all the information made
available to market participants at any given time. The efficient
market hypothesis (EMH) maintains that all stocks are perfectly
priced according to their inherent investment properties, the
knowledge of which all market participants possess equally. At first
glance, it may be easy to see a number of deficiencies in the
efficient market theory, created in the 1970s by Eugene Fama. At the
same time, however, it's important to explore its relevancy in the
modern investing environment.

*Tutorial:* Behavioral Finance
Financial theories are subjective. In other words, there are no proven
laws in finance, but rather ideas that try to explain how the market
works. Here we'll take a look at where the efficient market theory has
fallen short in terms of explaining the stock market's behavior.

EMH Tenets and Problems with EMH
First, the efficient market hypothesis assumes that all investors
perceive all available information in precisely the same manner. The
numerous methods for analyzing and valuing stocks pose some problems
for the validity of the EMH. If one investor looks for undervalued
market opportunities while another investor evaluates a stock on the
basis of its growth potential, these two investors will already have
arrived at a different assessment of the stock's fair market value.
Therefore, one argument against the EMH points out that, since
investors value stocks differently, it is impossible to ascertain what
a stock should be worth under an efficient market.

Secondly, under the efficient market hypothesis, no single investor is
ever able to attain greater profitability than another with the same
amount of invested funds: their equal possession of information means
they can only achieve identical returns. But consider the wide range
of investment returns attained by the entire universe of investors,
investment funds and so forth. If no investor had any clear advantage
over another, would there be a range of yearly returns in the mutual
fund industry from significant losses to 50% profits, or more?
According to the EMH, if one investor is profitable, it means the
entire universe of investors is profitable. In reality, this is not
necessarily the case.

Thirdly (and closely related to the second point), under the efficient
market hypothesis, no investor should ever be able to beat the market,
or the average annual returns that all investors and funds are able to
achieve using their best efforts.

This would naturally imply, as many market experts often maintain,
that the absolute best investment strategy is simply to place all of
one's investment funds into an index fund, which would increase or
decrease according to the overall level of corporate profitability or
losses. There are, however, many examples of investors who have
consistently beat the market - you need look no further than Warren
Buffett to find an example of someone who's managed to beat the
averages year after year.

*Qualifying the EMH*
Eugene Fama never imagined that his efficient market would be 100%
efficient all the time. Of course, it's impossible for the market to
attain full efficiency all the time, as it takes time for stock prices
to respond to new information released into the investment community.
The efficient hypothesis, however, does not give a strict definition
of how much time prices need to revert to fair value. Moreover, under
an efficient market, random events are entirely acceptable but will
always be ironed out as prices revert to the norm.

It is important to ask, however, whether EMH undermines itself in its
allowance for random occurrences or environmental eventualities. There
is no doubt that such eventualities must be considered under market
efficiency but, by definition, true efficiency accounts for those
factors immediately. In other words, prices should respond nearly
instantaneously with the release of new information that can be
expected to affect a stock's investment characteristics. So, if the
EMH allows for inefficiencies, it may have to admit that absolute
market efficiency is impossible.

*Increasing Market Efficiency?*
Although it is relatively easy to pour cold water on the efficient
market hypothesis, its relevance may actually be growing. With the
rise of computerized systems to analyze stock investments, trades and
corporations, investments are becoming increasingly automated on the
basis of strict mathematical or fundamental analytical methods. Given
the right power and speed, some computers can immediately process any
and all available information, and even translate such analysis into
an immediate trade execution.

Despite the increasing use of computers, however, most decision-making
is still done by human beings and is therefore subject to human error.
Even at an institutional level, the use of analytical machines is
anything but universal. While the success of stock market investing is
based mostly on the skill of individual or institutional investors,
people will continually search for the surefire method of achieving
greater returns than the market averages.

It's safe to say the market is not going to achieve perfect efficiency
anytime soon. For greater efficiency to occur, the following criteria
must be met: (1) universal access to high-speed and advanced systems
of pricing analysis, (2) a universally accepted analysis system of
pricing stocks, (3) an absolute absence of human emotion in investment
decision-making, (4) the willingness of all investors to accept that
their returns or losses will be exactly identical to all other market
participants. It is hard to imagine even one of these criteria of
market efficiency ever being met.

*by Jason Van Bergen*
Source: Investopedia.Com