Efficient Market Hypothesis: Investors Take Note!

¶ … efficient market hypothesis and its relation to securities prices, their response to new market information, investor opportunities, and behavioral finance challenges.

What does the efficient market hypothesis say about a) securities prices?

An efficient market is one in which "the market price of a security is an unbiased estimate of its intrinsic value" (Chandra, 2008). That is not to say that the market price for a security will equal its intrinsic value all the time. But what it does say is that there will be errors in market prices but they are not biased; and it does also say that while the price of securities can and will diverge from the intrinsic value of the securities but that deviation will be (in most cases) random. The divergence of the price from the intrinsic value will not be linked "with any observable variable" (Chandra, 422).

Because the deviations of the market price from the intrinsic value of the securities are strictly arbitrary, it makes it impossible to be able to identify securities that are over-valued or under-valued, Chandra explains (422). The three levels of market efficiency include: a) "weak-form efficiency" (prices reflect "all information found in the record of past prices and volumes"); b) "semi-strong form efficiency" (in addition to the record of past prices other information that is available to the public is included); and c) "strong-form efficiency" (the prices of securities reflect all the private and public information available) (Chandra, 422).

THREE: What does the efficient market hypothesis say about b) their reaction to new information?

Since the efficient market theory (also called the "random walk theory") doesn't state with certainty, but only implies, that prices will be determined by all available information, it then can be said that the market does not allow for "perfect forecasting abilities" (Chandra, 422). New information notwithstanding, the evidence gathered by experts is that in essence, investors are looking at new information with the hopes of getting a superior leg up on superiority, but "that may not be available" (Kiplinger, 1980). Trying to zero in on "winning stocks" may well be a "fruitless exercise" because the only way an investor can beat the stock market is "by chance" (Kiplinger, 27).

THREE: What does the efficient market hypothesis say about c) investor opportunities to make a profit?

Jodi Beggs writes that there is a sense of intuition behind the efficient market hypothesis, and that is, if the market price of securities seems a bit below what "available information" suggests it should be, by purchasing that asset an investor "could (and would) profit " from the investment (Beggs, 2011). But wait, other investors see that opportunity to make a profit as well, and hence there will be an increase in demand which raises the price of the assent and soon it no longer is "underpriced" (Beggs, p. 1).

On the other hand, if the market price of the securities seems above what the available public information reflects that it should be, the person holding those securities could profit be selling the asset outright (Beggs, p. 1). The increase in the supply of that stock would then lower the price until it was no longer overpriced.