Efficient market hypothesis

hi

There are three common forms in which the efficient market hypothesis is commonly stated — weak form efficiency, semi-strong form efficiency and strong form efficiency, each of which have different implications for how markets work.

Weak-form efficiency

• No excess returns can be earned by using investment strategies based on historical share prices.
• Weak-form efficiency implies that Techinical analysis techniques will not be able to consistently produce excess returns, though some forms of fundamental analysis may still provide excess returns.
• In a weak-form efficient market current share prices are the best, unbiased, estimate of the value of the security. Theoretical in nature, weak form efficiency advocates assert that fundamental analysis can be used to identify stocks that are undervalued and overvalued. Therefore, keen investors looking for profitable companies can earn profits by researching financial statements.

Semi-strong form efficiency

• Share prices adjust within an arbitrarily small but finite amount of time and in an unbiased fashion to publicly available new information, so that no excess returns can be earned by trading on that information.
• Semi-strong form efficiency implies that Fundamental analysis techniques will not be able to reliably produce excess returns.
• To test for semi-strong form efficiency, the adjustments to previously unknown news must be of a reasonable size and must be instantaneous. To test for this, consistent upward or downward adjustments after the initial change must be looked for. If there are any such adjustments it would suggest that investors had interpreted the information in a biased fashion and hence in an inefficient manner.

Strong-form efficiency

• Share prices reflect all information and no one can earn excess returns.
• If there are legal barriers to private information becoming public, as with insider trading laws, strong-form efficiency is impossible, except in the case where the laws are universally ignored. Studies on the U.S. stock market have shown that people do trade on inside information.
  
• To test for strong form efficiency, a market needs to exist where investors cannot consistently earn excess returns over a long period of time. Even if some money managers are consistently observed to beat the market, no refutation even of strong-form efficiency follows: with tens of thousands of fund managers worldwide^], even a normal distribution of returns (as efficiency predicts) should be expected to produce a few dozen "star" performers.