The efficient market hypothesis suggests that markets quickly incorporate new information, making it difficult for individuals to make guaranteed profits. It is based on the economic principle of arbitrage and predicts that the market follows a random walk. The hypothesis is controversial and only works if the market is filled with intelligent and rational agents who act on their assessments of trends and value. Real-world markets deviate from perfect efficiency, with some markets fitting the hypothesis better than others.
The efficient market hypothesis is the idea that markets rapidly take new information into account. In general, it explains why a random person can’t make a guaranteed profit by picking up the business section of a newspaper and buying stock in companies that appear to do well. According to the efficient market hypothesis, all this news will have already been taken into account by the share price; future events will affect the title 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 market flaw. A basic example of arbitrage would be buying something cheap when you know you can immediately sell it for more money. By applying the principle of information arbitrage, we obtain the hypothesis of an efficient market. The idea is that, if the information is available, it will have already been adopted.
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 time, any given stock, and the market as a whole, is equally likely to go up or down. The long-term trend of the market and all the stocks within it will therefore 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 for the remainder of the year, investment decisions will incorporate this future value, with appropriate discounting, into the current price.
By necessity, the efficient market hypothesis can always be only a rough approximation. For the hypothesis to work correctly, the market must be filled with a number of intelligent and rational agents who act on their assessments of trends and value. Paradoxically, if these agents all assumed the efficient market hypothesis, the system would collapse. The most active participants in the market 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 a large amount of data to the contrary, 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 a good description of an ideally functioning market. However, real-world markets all 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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