Efficient Market Hypothesis Essay Example | Topics and Well Written Essays - 1500 words

Efficient Market Hypothesis - Essay Example The efficient market theory assumes that there are no transaction costs, money market is not segmented and it is easy to enter the money markets. Efficient market hypothesis is explained in three ways. First, there is weak form efficiency. Weak form efficiency stipulates that all past information that is available in public domain is a reflection of stock prices. The prices are considered unbiased and best estimation of security value. It presumes that it is impossible to predict future prices using past information through technical analysis (Pompian, 2006). Therefore, an investor cannot use technical analysis to predict future prices that are likely to give excess profits (returns). Secondly, there is Semi-strong form efficiency. This form of efficiency stipulates that all publicly available information reflects prices of stock. It further states that prices adjust instantly as new information is made available. Fundamental analysis cannot be relied upon to generate excess returns to the investor. Thirdly, there is strong form efficiency. According to this form of efficiency, prices are reflected by both private (insider) and public information. This means that all investors irrespective of whether they have insider information or not, make equal profits on their investments. It further assumes that insider trading laws are usually enforced. This means that uninformed investors who purchase a diversified portfolio are likely to make same profits as those made by industry experts. Efficient market hypothesis is associated with ‘random walk’. Therefore, if information flow is not hampered and travels immediately in any investment especially stock pricing, the current price reflects current news (Boatright, 2010). Therefore, current prices depend on current news and not yesterday’s news. However, news is usually unpredictable and thus price changes of investments are also likely to be unpredictable and random. According to the efficient marke t hypothesis, news spread quickly and new information is quickly incorporated into the prices of investment in stocks without delay. This shows that there is no need for technical analysis from past price movements to predict movement of prices. Lee (2009) explained that efficient market hypothesis presumes that large number of profit maximizing investors exists. It also provides that new information must enter the market randomly and independently over time. Efficient market hypothesis has been challenged by economists who believe that there are psychological and behavioral factors that predict returns on investment. According to Malkiel (2003), the new breed of financial economists believes that prices are wholly or partially predictable based on behavioral patterns of individual investors and fundamental valuation metrics. They also argued that predictability of future stock prices enable investors to earn excess profits on their investments. A number of economists, statisticians and other experts have stated that Efficient Market Hypothesis (EMH) is to blame for the global financial crisis that occurred in 2007-2010. This is because of a number of reasons advanced by number of people. First, according to Jeremy Grantham, people had a lot of faith in efficient market hypothesis. This made them to throw caution in the air and underestimate the risk of assets bubbles because they believed that asset market was able to adjust itself accordingly (Nocera, 2009). The investors,