The efficient market hypothesis suggests that markets quickly incorporate new information, making it difficult for individuals to make guaranteed profits. The hypothesis is based on the economic principle of arbitrage and predicts that the market will follow a “random walk.” While controversial, it remains a central element of neoclassical economics.
The efficient market hypothesis is the idea that markets quickly take new information into account. Generally speaking, it explains why a random person can’t make guaranteed profits by picking up the business section of a newspaper and buying shares in companies that seem to be doing well. Under the efficient market hypothesis, all of this news will already have been factored in by the stock price; future events will affect the stock in unpredictable ways.
The economic principle underlying the efficient market hypothesis is arbitrage. Arbitrage is the practice of making a guaranteed profit by exploiting some flaw in the market. A basic example of arbitrage would be buying something at a low price when you know you can immediately sell it for more money. The application of the arbitrage principle to information generates the efficient market hypothesis. The idea is that if the information is available, it will already have been applied.
The strongest version of the efficient market hypothesis predicts that the market will follow a “random walk.” That is, it predicts that, at any given moment, any stock, and the market as a whole, is as likely to rise as it is to fall. The long-term trend of the market and all the actions within it will be nothing more than an accumulation of random decisions. Long-term trends should be impossible to identify. More precisely: as soon as trends become identifiable, they disappear, because investors will buy and sell stocks according to any apparent trend. By doing so, they deny it. If the stock can reasonably be expected to rise during the remainder of the year, investment decisions will incorporate this future value, at an appropriate discount, into the current price.
By necessity, the efficient market hypothesis can only be a rough approximation. For the hypothesis to work correctly, the market has to be filled with a series of intelligent and rational agents acting on their assessments of trends and value. Paradoxically, if all these agents assumed the efficient market hypothesis, the system would collapse. The most active market participants must believe, to some degree, that they are capable of making profitable decisions based on new information or assessments.
Because of this paradox, and because of the vast amount of data opposing it, the efficient market hypothesis is extremely controversial. It remains a central element of neoclassical economics, and is still widely taught. Many economists probably consider the hypothesis to be a good description of an ideally functioning market. However, real world markets deviate from perfect efficiency, some more than others. For example, the oil futures market, in which many well-informed and well-funded investors participate, probably fits the hypothesis better than the used car market.
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