Efficient Market Hypothesis states that stock prices reflect all available information. It would hold through the actions of market participants, who would buy or sell based on the “available information”. The theory implies that investors cannot consistently generate alpha (excess risk adjusted returns above the market), which in turn implies that markets cannot be timed and that the best strategy for investors is to invest passively at the desired level of risk.
The term was first coined in 1967 by Harry Roberts, after innumerous studies were conducted by economists trying to analyse price movements in stock markets. EMH sprouted from Roberts’ finding in 1956 that a random walk will look very much like an actual stock series. However, others, including Cootner (1962) and Steiger (1964), have concluded that the stock market does not follow a random walk. There have been contradictory findings over the last few decades about the validity of EMH and this article will try to set forth the economic rationale for both sides of the debate.
The first thing to consider is what is meant by “all available information”. Roberts defined EMH as three different forms, each having different implications on the possibility of alpha generation:
An assertion of the theory is that if a stock moved due to a trade unrelated to any new information, for instance, an individual liquidating a large holding due to a medical emergency, other market participants should buy the stock as the price falls to get it to a level that is supported by “all the information”.
In all the research, there is no clear definition or boundaries for “all information” or “all public information”. This is exacerbated by information asymmetries, which is when either the buyer or seller has more information about an investment instrument, thus making the definitions more subjective. As per an article published by Academia Revista Latinoamerica de Administracion, there is increased risk of asymmetric information in Latin American stocks with lower trading volumes and lower market capitalisation implying that small cap stocks in these markets are not efficient. There is no equitable access to information, especially in developing countries which do not have access to and knowledge of how to use information and communication technologies (ICT), which blurs these lines even further. A study considering 33 countries over a 15 year period showed strong evidence that the degree of asymmetric information decreases as financial systems develop. This leads to information asymmetries wherein even “public knowledge” may not be common to all market participants.
Therefore, it can be said that markets at a global level are not efficient at present, although some Forms of the Efficient Market Hypothesis might hold in the future, in an ideal market, as global economies develop.