Efficient Market Hypothesis Essay Example | Topics and Well Written Essays - 2000 words

Efficient Market Hypothesis - Essay Example While academics point to a large body of evidence in support of EMH, an equal amount of disagreement also exists. For example, investors such as Warren Buffett have consistently beaten the market over long periods of time, which by definition is impossibility according to the EMH. Critics of the EMH also point to events such as the 1987 stock market crash (when the DJIA fell by over 20% in a single day) as evidence that stock prices can seriously deviate from their fair values. (Investopedia, 2006, para.2) Wikipedia defines the Efficient Market Hypothesis (EMH) similar way. An assertion exists that financial markets are "efficient", or that prices on traded assets, e.g. stocks, bonds, or property, already reflect all known information and therefore are accurate in the sense that they reflect the collective beliefs of all investors about future prospects. The Efficient Market Hypothesis implies that it is not possible to consistently outperform the market - appropriately adjusted for risk - by using any information that the market already knows, except through luck or obtaining and trading on inside information. It further suggests that the future flow of news (that which will determine future stock prices) is random and unknowable in the present. The EMH is the central part of Efficient Market Theory (EMT). (Wikipedia: Efficient market hypothesis, 2006, para.1)Efficient Market Theory is a field of economics, which seeks to explain the workings of capital markets such as the stock market.... The EMH is the central part of Efficient Market Theory (EMT). (Wikipedia: Efficient market hypothesis, 2006, para.1) Efficient Market Theory is a field of economics, which seeks to explain the workings of capital markets such as the stock market. According to University of Chicago economist Eugene Fama, the price of a stock reflects a balanced rational assessment of its true underlying value (i.e., rational expectations); its price will have fully and accurately discounted (taken account of) all available information or news. The theory assumes several things including perfect information, instantaneous receipt of news, and a marketplace with many small participants (rather than one or more large ones with the power to influence prices). The theory also assumes that news arises randomly in the future (otherwise the non-randomness would be analyzed, forecast and incorporated within prices already). The theory predicts that the movements of stock prices will approximate stochastic processes, and that technical analysis and statistical forecasting will most likely be fruitless. (Wikipedia: Efficient market theory, 2006, para.1-2) It is a common misconception that EMH requires that investors behave rationally. This is not in fact the case. EMH allows that when faced with new information, some investors may overreact and some may under react. All that is required by the EMH is that investors' reactions be random enough that the net effect on market prices cannot be reliably exploited to make an abnormal profit. Under EMH, the market may, in fact, behave irrationally for a long period of time. Crashes, bubbles and depressions are all consistent with efficient market