Efficient Market Hypothesis Definition Forms Assumptions

Efficient Market Hypothesis Definition

Assumptions of EMH

Investors in the market may act rationally or normally. If there is unusual information, the investor will react unusually, which is normal behavior, or doing what everyone else is doing is also considered normal behavior.The stock price indicates all the relevant information shared universally among the investors.

Forms of Efficient Market Hypothesis

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The strength of the Efficient Market Hypothesis (EMH) theory’s assumptions depends upon the forms of EMH. The following are the forms of EMH: –

Weak Form: This form states that the stock prices indicate the public market information, and the past performance has nothing to do with future costs.Semi-Strong Form: This form states that the stock prices reflect both the market and non-market public information.Strong Form: This form says that public and private information instantly characterizes stock prices.

Example of the Efficient Market Hypothesis

Suppose a person named Johnson holds 900 shares of an automobile company, and the current price of these shares trades at $156.50. Johnson had some relations with an insider of the same company who informed Johnson that the company had failed in their new project and the price of a share would decline in the next few days.

Johnson had no faith in the insider and held all his shares. Then, after a few days, the company announces the project’s failure, dropping the share price to $106.00.

The market modifies the newly available information. To realize the gross gain, Johnson sold his shares at $106.00 and a gross gain of $95,500. If Johnson had sold his 900 shares at $156.50 earlier by taking the insider’s advice, he would have earned $140,850. So, his loss for the sale of 900 shares is $140,850-$95,500 i.e., $45,350.

Criticism

Existence of Market Bubbles: One of the biggest reasons behind the criticism of the efficient market hypothesis is market bubbles Market BubblesA stock market bubble is a phenomenon in which the prices of a company’s stock are inflated and cannot be supported by the company’s actual performance, resulting in a divide between the real and financial economies caused by irrational exuberance of market participants, herd mentality, or any other similar reason.read more. So, if such assumptions were correct, there was no possibility of bubbles and crashing incidents such as stock market crash Stock Market CrashA stock market crash occurs when stock prices in all sectors begin to fall rapidly. It is often the result of global factors such as war, scam, or the collapse of a certain industry. In such a crash, panic acts as a catalyst.read more and housing bubblesHousing BubblesA housing bubble is a duration in which the cost of houses and other real estate properties increases dramatically at the local or global level. The prices can continue to grow at any time until the supply eventually catches up. The trend can end with a sudden drop in house prices, causing the bubble to burst.read more in 2008 or the tech bubble of the 1990s. Such companies were trading at high values before hitting.Wins against the Market: Some investors, such as Warren Buffett, won against the market consistently. He had consistently earned above-average profit from the market for over 50 years through his value investing strategy. On the other hand, some behavioral economists also highly criticize the efficient market hypothesis theory because they believe that past performances help predict future prices.

Implication

The efficient market hypothesis implies that the market is unbeatable because the stock price already contains all the relevant information. It created a conflict in the minds of the investors. They started believing they could not beat the market as it is not predictable, and future prices depend upon today’s news, not the trends or the company’s past performances. However, many economists criticized this theory.