What is The Efficient Market Hypothesis – EMH?

Welcome to the Investors Trading Academy talking
glossary of financial terms and events. Our word of the day is “Efficient Market
Hypothesis” You can’t beat the market. The efficient market
hypothesis says that the price of a financial asset reflects all the information available
and responds only to unexpected news. Thus prices can be regarded as optimal estimates
of true investment value at all times. It is impossible for investors to predict whether
the price will move up or down as future price movements are likely to follow a random walk,
so on average an investor is unlikely to beat the market. This belief underpins ­arbitrage
pricing theory, the capital asset pricing model and concepts such as beta.
The hypothesis had few critics among financial economists during the 1960s and 1970s, but
it has come under increasing attack since then. The fact that financial prices were
far more volatile than appeared to be justified by new information, and that financial bubbles
sometimes formed, led economists to question the theory. Behavioral economics has challenged
one of the main sources of market efficiency, the idea that all investors are fully rational
homo economicus. Some economists have noted the fact that information gathering is a costly
process, so it is unlikely that all available information will be reflected in prices. Others
have pointed to the fact that arbitrage can become costlier, and thus less likely, the
further away from fundamentals prices move. The efficient market hypothesis is now one
of the most controversial and well-studied propositions in economics, although no consensus
has been reached on which markets, if any, are efficient. However, even if the ideal
does not exist, the efficient market hypothesis is useful in judging the relative efficiency
of one market compared with another.

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