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Market Efficiency & Efficient Market Hypothesis

The Efficient Market Hypothesis (EMH)

Definition: Asset prices fully reflect all available information.

Implication: Cannot consistently beat the market using available information.

Three Forms of EMH

Weak Form:

  • Prices reflect all past price/volume data
  • Technical analysis useless
  • Evidence: Mostly supported

Semi-Strong Form:

  • Prices reflect all publicly available information
  • Fundamental analysis useless
  • Evidence: Mixed

Strong Form:

  • Prices reflect all information (public + private)
  • Even insider information can't beat market
  • Evidence: False (insider trading laws exist for a reason)

EMH Assumptions

Rational Investors: Unbiased processing of information

Arbitrage: Rational traders correct any mispricings instantly

Random Walk: Price changes unpredictable

Behavioral Challenges to EMH

Anomalies EMH can't explain:

  • Momentum: Stocks that rose keep rising (6-12 months)
  • Value Premium: Low P/E outperform high P/E
  • Size Effect: Small caps beat large caps
  • January Effect: Abnormal January returns
  • IPO Underpricing: First-day pops average 15-20%

Behavioral Explanation: Systematic investor biases create predictable patterns.

Limits to Arbitrage

Why don't rational traders eliminate mispricings?

Costs: Transaction costs, bid-ask spreads

Risks:

  • Fundamental risk (company-specific)
  • Noise trader risk (irrational investors push prices further wrong)
  • Implementation risk (short-selling constraints)

Horizons: Arbitrage takes time; managers face quarterly pressures

Example: During 2000 dotcom bubble, rational traders who shorted overvalued tech stocks lost money as prices went higher. Many were forced out before eventual correction.

Behavioral Finance View

Markets are "adaptively efficient":

  • Mostly efficient most of the time
  • Periodic mispricings due to behavioral biases
  • Exploitable by patient, disciplined investors
  • Efficiency varies across time, markets, securities

Evidence:

  • Index funds beat 80%+ of active funds (supports EMH)
  • But momentum, value strategies work (challenges EMH)
  • Bubbles occur (2000 tech, 2008 housing) then correct

Key Takeaways

  • EMH: Prices fully reflect information; can't beat market
  • Three forms: Weak (past prices), semi-strong (public info), strong (all info)
  • Anomalies: Momentum, value, size effects challenge EMH
  • Limits to arbitrage: Costs, risks, horizons prevent instant correction
  • Behavioral view: Markets mostly efficient but periodic mispricings from biases

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