What Does the Efficient Market Hypothesis Claim?
The Efficient Market Hypothesis states that when new information becomes available, the market absorbs the news almost in real time, adjusting stock prices and other securities accordingly. Those who agree with this theory say the market is very adept at incorporating all known data, such that no analysis can provide an advantage over the millions of other people who also have access to the same information.
How Does This Affect the Market?
Once the Efficient Market Hypothesis became known, it could be seen in action in the market. For example, index funds were bought and sold at a much higher rate. This effect should not be surprising. After all, if expert traders or stockbrokers do not have a real edge over others and do not beat the “market,” why pay them higher fees in hopes of achieving better performance?
Why Do People Try to Beat the Market?
Until March 2020, 41% of exchange-traded funds (ETFs) and mutual fund assets in the United States were passive funds, compared to just 3% in 1995. The use of passive funds is clearly on the rise, and according to Bloomberg, the amount of money held in passive assets is expected to surpass that held in active assets by 2026 or sooner.
How Does the Risk Factor Affect This?
Those who agree with the Efficient Market Hypothesis will say that the examples above are merely a push for risk-taking. For instance, an investor who bought a home or property at its lowest point during the recession in 2009 made a good profit because of the risk they took.
Markets Are Not Rational
Note that the Efficient Market Hypothesis does not mean that markets are rational or that they always price assets perfectly accurately. In the short term, investments can become overvalued (think of tech stocks during the dot-com bubble or real estate during the housing bubble) or undervalued (think of stock prices in March 2009). The value or estimated value of assets in the market has much to do with investor confidence and their willingness to take risks.
Over the longer time horizon, investment prices will reflect the expected earnings growth of the underlying assets. The Efficient Market Hypothesis has been a subject of debate among scholars in this field since it emerged in the 1960s.
All data points to the fact that long-term investing is a more sound way than trying to make quick money. This alone may suggest that there is more to the Efficient Market Hypothesis than critics are willing to admit.
Sources:
– Burton G. Malkiel. “The Efficient Market Hypothesis and Its Critics,” Pages 59-60. Journal of Economic Perspectives.
– Morningstar. “A Brief History of Indexing.”
– Federal Reserve Bank of Boston. “The Shift From Active to Passive Investing: Potential Risks to Financial Stability?” Pages 1-2.
– Bloomberg Intelligence. “Passive Likely Overtakes Active by 2026, Earlier if Bear Market.”
– The Economist. “Is Efficient-Market Theory Becoming More Efficient?”
– Deutche Bank Research. “High-Frequency Trading: Reaching the Limits,” Page 2.
– FRED Economic Data. “Median Sales Price of Houses Sold for the United States.”
– Federal Reserve Bank of Atlanta. “Stock Prices in the Financial Crisis.”
– UCL Department of Computer Science. “History of the Efficient Market Hypothesis,” Pages 3-7.
Source: https://www.thebalancemoney.com/the-efficient-market-hypothesis-in-simple-terms-2388640
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