The efficient market hypothesis essay

EMH definition This term was invented in 1960 by Eugene Fama. According to the definition, a market is efficient if the next three things are fulfilled: the prices of the market reflect all the information rapidly and accurately, and are available to sellers and buyers; there are no individual dominators in the market; transaction cost of selling and buying are not high that discourages trading. The EMH deals with a very important issue in finances, it explains why prices change in markets and how these changes happen. This is a very important question for both financial managers and investors. The EMH suggests that getting a profit from predicting price changing is quite difficult. The engine of changing prices is the new information, so the market can be effective if prices change quickly and without prejudgment to new information that arrives constantly. As a result of this process, the prices reflect the information available for any point of time. Three forms of EMH As we said above, the EMH presumes that prices on the market should consolidate all available information at the point of time. But there are different sorts of information that can influence prices, so financial researches define three forms of the EMH depending on the information: Weak EMH form – according to this definition, the current price includes information that contains only in the past history of market prices. In this way its impossible to predict changing price in the future. Semi-strong EMH form – according to this definition, the current price includes all publicly information. The public information contains not only public prices, but also such facts as financial statements, dividend and earnings announcements, the company financial situation, etc. It means that nobody can get a profit using a public information, because everybody knows it. Strong EMH form – this definition states that the current price includes all information, both private and public. Implications of market efficiency for financial managers If the market is efficient, here are the main implication for financial managers: The price always reflects the worth of the company, without any valuation, because prices in the market are fair. Anyone cant use creative accounting techniques, misleading the markets. The managers should ensure that all investments exceed the cost of capital of the company. Its possible to sell a lot of new shares without lowering the price. Its impossible and useless for the company to try changing the markets view because the market will decide itself what level of return is required for the involved risk. Takeovers and merges may be questioned if share are correctly priced. Implications of market efficiency for individual investors Equity research is expensive and pointless because it provides no benefits for the company. Its better to use strategies that require minimal execution costs (for example, indexing to the market or randomly diversified portfolio are perfect). The strategy that have minimal transaction costs should give higher returns in the long period. So, individual investors cant make good profits by using active management strategies. Such methods wouldnt work out, and they even able to reduce returns of the company. Instead, investors should use passive strategies that have no attempts of beating the market. Returns can be easily optimized by asset allocation and by reducing investment taxes and costs. If the market is efficient, there is less possibility to make a speculative profit. Needless to say that the main goal of all investors is to get the highest returns. Each year we see new tons of new published books from professional investors that suggest ways how to beat the market and earn big money. Unfortunately, these strategies wont work out because the competition between investors creates the efficient market where prices change rapidly to the information. In other words, active security management is not a winning position. Of course there is no perfect theory, but the majority of empirical evidence supports the EMH. And after all, the efficient market hypothesis stays the best specification of price movements in markets of securities.