Efficient Markets Hypothesis – Theory & Definition

An efficient securities market is one where the prices of securities traded on that market at all times “properly reflect” all information that is publicly known about those securities.

Noteworthy Points of the Theory

First, market prices are efficient with respect to publicly known information.
The possibility, therefore, of inside information is not ruled out. Persons who possess inside information know more about the company than the market. If they wish to take advantage of their inside information, insiders may be able to earn excess profits on their investments. This is because the market prices of these investments do not incorporate the knowledge that insiders possess. Market prices reflect information that is available in the public domain.

Second, market efficiency is a relative concept.
The market is efficient relative to the quantity and quality of publicly available information. There is nothing in the definition to suggest that the market prices always reflect real underlying firm value. Market prices can be wrong in the presence of inside information, for example. The definition does imply, however, that once new or corrected information becomes publicly available, the market price will quickly adjust to this new information. This adjustment occurs because rational investors will revise their beliefs about future returns as soon as new information, irrespective of the source, becomes known. As a result, the expected returns and risk of their existing portfolios will change and they will enter the market to restore their optimal risk/return tradeoffs. The resulting buy-and-sell decisions will quickly change security prices to reflect the new information.

Third, investing is fair game if the market is efficient.
This means that investors cannot expect to earn excess returns on a security, or portfolio of securities, over and above the normal expected return on that security or portfolio. One way to establish a normal return benchmark is by means of a capital asset pricing model.

Implication of the hypothesis
An implication of securities market efficiency is that a security’s market price should fluctuate randomly over time. The reason being anything about a firm that can be expected will be properly reflected in its security price by the efficient market as soon as the expectation is formed. The only reason that prices will change is if some relevant, but unexpected, information comes along and unexpected events occur randomly.

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