The Efficient Market Hypothesis - CFA Level 1 | Investo…
CFA Level 1 - The Efficient Market Hypothesis
We often find ourselves comparing misconceptions about market efficiency (including by some very smart people) to familiar sports clichés like “defense wins championships.” What we mean is that it’s entirely possible to take the idea too literally, especially if you don’t fully understand the context.
Learn the basics of the efficient market hypothesis
The most common and dangerous misunderstanding about the efficient market hypothesis (EMH) is that it means financial markets are efficiently priced and that therefore investors should not worry about whether markets look relatively rich or cheap when making investments.
Efficient-Market Hypothesis Eugene Fama Nobel Prize
Fama is most often thought of as the father of , beginning with his Ph.D. thesis. In a ground-breaking article in the May, 1970 issue of the , entitled "Efficient Capital Markets: A Review of Theory and Empirical Work," Fama proposed two crucial concepts that have defined the conversation on efficient markets ever since. First, Fama proposed three types of efficiency: (i) strong-form; (ii) semi-strong form; and (iii) weak efficiency. They are explained in the context of what information are factored in price. In weak form efficiency the information set is just historical prices, which can be predicted from historical price trend; thus, it is impossible to profit from it. Semi-strong form requires that all public information is reflected in prices already, such as companies' announcements or annual earnings figures. Finally, the strong-form concerns all information, including private information are incorporated in price; it states no monopolistic information can entail profits, in other words, insider trading cannot make a profit in the strong-form market efficiency world. Second, Fama demonstrated that the notion of market efficiency could not be rejected without an accompanying rejection of the model of market equilibrium (e.g. the price setting mechanism). This concept, known as the "," has ever since vexed researchers. Market efficiency denotes how information is factored in price, Fama (1970) emphasizes that the hypothesis of market efficiency must be tested in the context of expected returns. The joint hypothesis problem states that when a model yields a return significantly different from the actual return, one can never be certain if there exists an imperfection in the model or if the market is inefficient. Researchers can only modify their models by adding different factors to eliminate any anomalies, in hopes of fully explaining the return within the model. The anomaly, also known as alpha in the modeling test, thus functions as a signal to the model maker whether it can perfectly predict returns by the factors in the model. However, as long as there exists an alpha, neither the conclusion of a flawed model nor market inefficiency can be drawn according to the Joint Hypothesis. Fama (1991) also stresses that market efficiency per se is not testable and can only be tested jointly with some model of equilibrium, i.e. an asset-pricing model.