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The truth about the efficient market hypothesis: Does the market really reflect all information?
The efficient market hypothesis (EMH) is a theory in financial economics that states that asset prices reflect all available information. An important corollary of this hypothesis is that investors cannot consistently “beat the market” on a risk-adjusted basis because markets price expectations only in response to new information. Since the 1990s, research in financial economics has focused on market anomalies, that is, deviations from particular risk models. This raises a number of questions about whether markets can really be so efficient.
The theoretical basis of the efficient market hypothesis is that asset prices should be priced based on future cash flows and risks.
The idea that financial market returns are difficult to predict was first proposed by people like Bachelier and Samuelson in the early 20th century, but the concept became more well-known under the influence of Eugene Fama. In a review article in 1970, Fama summarized the theoretical and empirical research on this theory and provided the basic logic of modern risk-based asset pricing theory. Since then, EMH has become an important reference point for financial market research.
However, empirical findings on return predictability are mixed. While studies in the 1950s and 1960s often found forecast invalidations, the 1980s to 2000s saw a large number of discovered return predictors. However, since the 2010s, relevant studies have found that the effectiveness of forecasts has become increasingly unclear, and many models are unable to make effective predictions outside of the sample. These results make people wonder how effective the market is?
The difficulty in predicting market returns reflects the close connection between market efficiency and random walk theory.
The core of the efficient market hypothesis is that markets react quickly to available information. Assuming that a piece of information (for example, a prediction of a future merger) has become widely disseminated, if the stock price does not reflect this information, investors may trade on the information until the price corresponds to the new information. However, the market's reaction does not mean that future price movements are necessarily unpredictable.
In the context of EMH, the efficiency of the stock market has been subjected to several empirical tests, including weak-form, semi-strong-form, and strong-form efficiency tests. These tests examine whether stock market prices statistically reflect all available information. Although Fama's theory provides a robust model for financial markets, many investors and economists question its practicality and reliability.
The market is not completely civilized, and investors' emotions and behaviors often affect stock trading and price fluctuations.
Behavioral economists such as Daniel Kahneman and Richard Thaler attribute the imperfections of financial markets to investors' cognitive biases. These biases suggest that even in an efficient market, investors often make irrational decisions. These views fundamentally challenge the efficient market hypothesis.
As more and more market anomalies are discovered, such as the excess returns of small-cap and value stocks, people are questioning the full validity of the EMH. Such research results have prompted scholars to gradually shift from the CAPM model to models based on risk factors, such as the Fama-French three-factor model. This shift has undermined the foundation of the traditional efficient market hypothesis.
Competitive market theory suggests that self-interested traders will actively seek out and exploit information asymmetries in the market to achieve their own interests. Is past experience really enough for us to trust the theory of efficient markets? Relying solely on theoretical and empirical debates is probably not enough to explain the true workings of the market. On this basis, are investors' internal barriers and emotions preventing us from fully understanding the efficiency of the market?
Many observers believe that cryptocurrencies such as Bitcoin are perhaps the best example of market inefficiency because their value fluctuations are heavily dependent on investor sentiment.
Famous investors like Warren Buffett and George Soros often question the efficient market hypothesis with their outstanding investment returns. They believe that efficient markets overemphasize theory and ignore the many variables in actual investing. It is worth noting that Buffett also advocates that most investors should rely on index funds to pursue the market's average return.
Overall, the efficient market hypothesis is undoubtedly an important theory in finance, but as time goes by, the complexity of empirical research and market behavior has also given rise to more discussions and reflections. Does the market really reflect all information?
