How True is the Efficient Market Hypothesis?

Eugene Fama first introduce his Efficient Market Hypothesis (“EHM”) back in 1970. In summary, EHM states that stock markets are efficient in the sense that new information are being reflected in the prices as soon as it is being known to the public. EHM implies that the securities prices follow a random walk movement. This means that subsequent changes in the security price doesn’t depend on the current or previous prices. Burton Malkiel’s 1973 paper titled A Random Walk Down Wall Street mentioned that a chimpanzee could select a portfolio that performs as well as the experts by just throwing darts blindfolded. However, several studies by academicians has shown that the reflection of new information in the stock prices are quite immediate. In other words, there are some delay in this price reflection. Thus, the notion of 3 forms of market efficiency:

  1. weak form
  2. semi-strong form
  3. strong form of efficiency

There are attacks on EHM particularly the belief that stock prices are not predictable. There are anomalies in the market ranging from Monday effect to year-end holiday effect. In other words, these anomalies has shown that stock prices do follow some pattern which has been shown in the past. Therefore, there are some form of predictability. Note that predicting is far more certain than forecasting. The critics of such predictive power by just observing historical pattern is the robustness of the statistics. It needs to go through statistical testing whether such statistics are highly sensitive to a certain period of time, whether such anomalies happen by chance or when would such statistics fail.

Careful readers would find out that the perspective of EHM and its critics’ perspective are different in totality. The main difference is that EHM establishes the notion that stock markets can’t be predicted while the other is taking a reactive stand. In other words, based on historical events, an investor should react such and such to benefit most out of the situation. Therefore, based on the investor’s belief on predicting the stock market or taking a reactive stand would set his view of the truth about EHM.

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