There have been differences in ideas from one person to another on what market efficiency is. As such it has drawn both positive and negative criticism on what it really is. Markets are often analyzed on how efficient they are, and if not where the inefficiencies are. This helps in the determination of the value of assets and hence enables investors to be able to make informed decisions on investments they want to make. However, inefficient markets make it harder to value assets and thus can result in undervaluing or overvaluing the true market value of an asset which more often than not leads in making or uninformed investment decisions. Various theories have been advanced with the aim of classifying market efficiency however; the Efficient Market Hypothesis (EMH) framework is the most suitable of all. This report shall give a deeper analysis of this theory and clearly states the advantages and disadvantages of this framework.
Efficient Market Hypothesis Framework
For the past over 60 years, Efficient Market Hypothesis framework has been the dominant theory in making investment decisions. Academic financial economists have a wide acceptance of this approach in market efficiency classification. According to (Woolley and Vayanos, 2009) efficient markets do not allow investors to earn above average returns without accepting above-average risks. This particular framework uses news, information and communications to define how efficient a market is.
Efficient markets experience understandable profit through active competition among each other so as to forecast future market values of each security, and where valuable information is equally available to all participants. This implies that, the valuation of a security or asset is reached at based on the information about that security that is available publicly. Such information is oftenly used by the analysts and economists to reach and intelligent and well-informed decisions about the various securities and assets in the market.
Fama developed a classification model for market efficiencies into three different forms:
Here, all past share prices are reflected in the capital market. As a result, security prices change irrespective of the past share or security prices.
This utilizes financial information which is publicly available, such as journals, press conferences, annual financial reports and listed companies, to determine a market price for a security or asset. Investors who hold insider information that is not in the public domain, should not utilize such for their personal gain.
An efficient market in this form utilizes all the available information on the security, both public and private so as to come up with market prices for that security or asset. It is worth to note that an efficient market in the strong form is not a perfect market. This is because, despite the assertion by (Francis, 2009) that well-adjusted security prices hinder investors with insider information from taking advantage of the market, there continues to be instances where investors have used inside information to gain an edge over other investors who dont have access to such information.
Advantages of the Efficient Market Hypothesis Framework
It is informationally efficient. This indicates that all investors can have access to readily available information.
Ease of both fundamental and technical analysis. Once the analysts and economists have the required information, all that they have to do is use various tools to be able to analyze and predict market prices of various securities.
It treats all investors, analysts and economists as uniform without any bias.
Disadvantage of the Efficient Market Hypothesis Framework
Availability and accessibility of information varies. Information can be available in a website, some news channel, blog or journal but for one reason or another an investor, analyst or economist might not have access to this information and as a result making him/her to be disadvantaged over the competitors.
Using the EMH Framework, investors, analysts and economists alike can be able to come up with true market values of various securities in the financial market. Once information is available and gets accessed by these specialists, then they are able to carry out both fundamental and technical analysis to be able to come up with security prices. In fundamental analysis, financial information of a portfolio and its assets is accessed and a picture of the company is formed and then a confidence relationship is fostered between the portfolio and the company with securities (Russel and Torbey, 2008). In technical analysis, past market prices of securities are used to help in the prediction of future market prices with similar characteristics. This means that past occurrences and patterns are bound to recur again and as such the previous trends should not be treated as memories. In this regard, the EMH framework is by far very reliable in the classification of market efficiency and gives a higher confidence level in the determination of the prices of securities than other framework theories that are dependent on emotions and thoughts of various individuals.
Woolley, P. and Vayanos, D. (2009) Capital market theory after the efficient market hypothesis. Available at: http://voxeu.org/article/capital-market-theory-after-efficient-market-hypothesis (Accessed: 8 November 2016).
Francis, R. (2009) Efficient market hypothesis: Strong, Semi-Strong, and weak. Available at: http://www.obliviousinvestor.com/efficient-market-hypothesis-strong-semi-strong-and-weak/ (Accessed: 8 November 2016).
S. Russel, P. and M. Torbey, V. (2008) THE EFFICIENT MARKET HYPOTHESIS ON TRIAL. Available at: http://www.westga.edu/~bquest/2002/market.htm (Accessed: 8 November 2016).
Bernhardsson, J. (2002). Trading Guide: All you need to know about financial market. Stockholm: Fischer & Co.
Fama, E. (2007). Efficient Capital Markets: A review of theory and empirical work, The Journal of Finance, Vol.25, No 2, pp.383-417.
Haugen, R. (2001). Modern Investment Theory. New York: Prentice Hall, 5th Edition.
Malkiel, B. (2003). The Efficient Market Hypothesis and Its Critics, Journal of Economic Perspectives, Vol.17, No 1, pp. 59-82.
Vinell, L. and Ridder, A. (2009). Stocks risk and return. Stockholm: Norstedts.
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