Efficient Market Theory¶
Introduction¶
Stock prices are influenced by a variety of factors which can be categorized into:
- Fundamental Factors: These include the economic, financial, and other tangible aspects influencing a company's actual business performance.
- Technical Factors: These focus on statistical analysis of market activity, primarily price and volume.
- Psychological Factors: These encompass investor behavior, market sentiment, and other similar influences.
The behavior of stock prices can be approached via two primary methods:
- Fundamental Analysis: This method evaluates the intrinsic value of securities by examining related economic, financial, and other qualitative and quantitative factors.
- Technical Analysis: This analysis believes that past stock price movements can predict future price behavior.
Third Theory: Random Walk Theory¶
A third theory challenges the assumptions behind technical analysis, particularly the notion that stock price movements are orderly and predictable. This theory suggests that stock prices follow a 'random walk' and are inherently unpredictable because they react to news in an unpredictable and random manner.
Random Walk Theory¶
The Random Walk Theory posits that changes in stock prices occur only due to new information affecting the economy, industry, or a particular company. According to this theory:
- Changes in stock prices happen in response to fresh, unpredictable information.
- Since new information is random and unpredictable, stock price movements are also random and independent of each other.
This theory underscores the efficiency of the stock market, positing that prices adjust almost instantly to new information due to a highly efficient and competitive market environment enabled by rapid communication systems.
Efficient Market Hypothesis (EMH)¶
The Efficient Market Hypothesis expands on the ideas of the Random Walk Theory. It states that:
- An efficient capital market is one where security prices always fully reflect all available information.
- In such a market, it is not possible to consistently achieve returns that exceed average market returns, on a risk-adjusted basis, given the information available at the time the investment is made.
Forms of Market Efficiency¶
Market efficiency can be classified into three forms:
- Weak Form: This form asserts that all past market prices are fully reflected in securities prices. Therefore, technical analysis cannot be used to predict and beat the market.
- Semi-strong Form: This form states that all publicly available information is fully reflected in stock prices, not just past prices. Thus, fundamental analysis cannot achieve superior returns.
- Strong Form: This form claims that all information, public and private, is accounted for in stock prices. Therefore, no one can have an advantage in predicting and beating the market.
EMH vs. Fundamental and Technical Analysis¶
While the Efficient Market Hypothesis suggests that neither technical nor fundamental analysis can outperform the market consistently:
- Fundamental Analysis seeks to uncover mispriced stocks by analyzing relevant data.
- Technical Analysis assumes that history tends to repeat itself and uses past trends to predict future price movements.
Interestingly, the paradox of the EMH is that the market needs both fundamental and technical analysis to remain efficient. These analyses are necessary as they contribute to the market's ability to price securities accurately, validating the EMH by ensuring that all available information is reflected in stock prices.
Conclusion¶
Efficient Market Theory, through its exploration of the Random Walk Theory and EMH, presents a compelling argument that stock prices are effectively unpredictable and consistently reflect all available information. This underscores the challenges of achieving above-average returns through either fundamental or technical analysis in an efficient market.
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