Efficient Market Theory

Efficient Market Theory

See Also:
Economic Indicators
Economic Value Added
Supply and Demand Elasticity
Business Cycle
Porters Five Forces of Competition

Efficient Market Theory

Efficient market theory hypothesis proposes that financial markets incorporate and reflect all known relevant information. The validity of efficient market hypothesis is debated; however, whether or not efficient market hypothesis is valid, it is useful as a theoretical concept with which to study financial market phenomena.

Efficient Market Assumptions

Efficient market hypothesis is based on several assumptions. It also assumes that all relevant information is reflected in the stock markets. Efficient market hypothesis assumes a financial security is always priced correctly. Furthermore, this implies that stocks are never undervalued or overvalued. It also implies that investors can never consistently outperform the overall market, or “beat the market,” by employing investment strategies.

Degrees of Efficient Market Hypothesis

According to efficient market hypothesis, there are three forms of market efficiency including the following:

  • Weak-form efficiency
  • Semi-strong-form efficiency
  • Strong-form efficiency

The different forms represent different degrees of adherence to efficient market hypothesis.

Weak Form Market Efficiency

According to weak-form market efficiency, reflect all historic price data in a stock’s current market price. This implies you cannot use technical analysis to outperform the overall market. However, this form of market efficiency does allow for security mispricings that investors can discover and exploit through fundamental analysis.

Semi Strong Efficient Market Hypothesis

According to semi-strong-form market efficiency, reflect all public data (including all historical data and all current financial statement data) in a stock’s current market price. Furthermore, this implies that neither technical analysis nor fundamental analysis can be utilized to outperform the overall market. However, this form of market efficiency does allow for security mispricings due to private information. So investors with access to private information may be able to earn excessive returns.

Strong Form Market Efficiency

According to strong-form market efficiency, reflect all data – historic and current, public and private – in a stock’s current market price. Furthermore, this form of market efficiency implies that there is no way to achieve excessive returns in financial markets.
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