What is... | October 2, 2012

What is the efficient markets theory?

If you knew a certain car had a fault, would that information change the price you were prepared to pay for it? The answer is almost certainly “yes” - you would ask for money off the price to compensate for the fault.

According to the efficient markets theory – or hypothesis, as it is sometimes called – share markets operate in a similar way, pricing in information about companies so shares usually trade at or near “fair value”. However, the theory is not universally accepted and in past decades has been challenged by a range of counter theories – including arguments from behavioural economists that emotions play a role in investing.

Weak, semi-strong and strong
The efficient markets theory comes in different strengths – weak, semi-strong and strong. The weak theory says public information from the past has been priced into assets, the semi-strong that past public information is priced in and prices instantly change when new information emerges. The strong version says even hidden or insider information is reflected in prices.

Can we “beat the market”?
A key reason the efficient markets theory is so important to investors is it strikes at the heart of whether investors can “beat the market” by buying under-priced shares that will rise sharply in value or selling when prices are above fair value. Writing in the Journal of Economic Perspectives, academic and author Burton Malkiel explained the efficient market theory was associated with another key share market idea – the “random walk”. The random walk idea is that share prices reflect publicly available information but that the flow of information is unpredictable and therefore results in unpredictable price changes.
Malkiel penned an influential book called A Random Walk Down Wall Street,  first published in 1973, in which he claimed “a blindfolded chimpanzee throwing darts at the Wall Street Journal could select a portfolio that would do as well as the experts”. At the time, he urged investors to buy broad-based index funds with low fees given the difficulty picking under-priced shares. Malkiel’s arguments lie at the heart of the debate about the relative merits of active and passive investing.
The 2003 paper outlines arguments against the efficient markets theory but Malkiel writes that although markets may occasionally deviate from their fair price “true value will win out in the end”. Likewise, a 2008 review plotting the past, present and future of the efficient markets theory contends it is here to stay and will continue to play an important role in modern finance for years to come.

Herd investing, calendar effects and more
There are counter arguments to the efficient market theory.
If information is not readily available, for example, the market cannot price it in and reach “fair value”. This means the theory cannot operate in the real world, at least in its strongest form. An example might be the movements in the share market during the global financial crisis that started in 2007. The movements were so sudden, so big and so unpredictable some say that the market couldn’t have moved quick enough to react to be efficient.
Behavioural economics also provides some counter arguments based on the way people make decisions. It says sometimes decisions are affected by emotion and may not take in to account all relevant information. Herd investing  is an example of emotion rather than efficient markets-style logic driving decision making. In his fifth video lesson  for investors from the financial crisis, ING global chief economist Mark Cliffe argued “the market isn’t always right”. Cliffe said emotional investing – driven by fear and greed – presented “many bargains to be snapped up by expert investors”.
Likewise, the January effect and other claimed “calendar effects” are frequently cited as contrary to the efficient markets theory because influences other than company information are said to come into play.


eZonomics team
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