Efficient Markets, Theory of

The theory of efficient markets postulates that in a wellfunctioning capital market, the best estimate of the value of a financial security is today's price. This relationship holds because the current price of an asset reflects all the information available to buyers. According to the efficient markets hypothesis (EMH), stock prices change only when new information becomes available or discount rates change. In defense of the theory, EMH advocates point out the so-called random walks of stocks and (more generally) securities through time; that is, price changes are unpredictable because prices respond only to new information (and the newness of information, by definition, makes it unpredictable). In case of investor disagreements about the value of a security, share price valuations will converge around the “true value” over time because either incorrect valuations disappear due to a presumed process of natural selection (learning) or arbitrageurs interpret information correctly and can profit from these disagreements among investors. Overall, these market dynamics decrease market volatility, which is a central prediction of EMH. Furthermore, EMH predicts trading volumes in financial markets to be limited because rational investors cannot agree to disagree when they have the same information.

The general definition and explanation of EMH above are most consistent with the semistrong form of EMH: Current market prices reflect all publicly available information. Other forms are the weak form (all information contained in past price movements is fully reflected in current market prices) and the strong form (current market prices reflect all pertinent information, whether publicly available or privately held). Studies generally found that whereas the weak form and the semistrong form of EMH typically hold, the strong form generally receives little or no empirical support. These conclusions about strong-form EMH are supported by the fact that inside traders are able to make abnormal profits.

The theory of efficient markets has had a lot of success since its conception and further theoretical development by, among others, Eugene Fama and Myron Scholes. EMH became widely known after Fama's seminal article in 1970. Over time, it was widely accepted as the orthodox model of academic finance and spawned the options-pricing model that [Page 660]created the derivatives industry. Moreover, investment strategies tied to indexed funds are a manifestation of the idea that no investor can consistently second-guess or outperform the market.

Undoubtedly, this latter implication of efficient markets theory usually holds: It is very difficult for any investor to beat the market consistently. However, there is no empirical evidence that markets are always right or that market prices represent rational assessments of fundamental values. Behavioral finance scholars, such as Robert Shiller, Andrei Shleifer, and Hersh Shefrin, have shown to what extent psychological heuristics and biases can affect buyers' and sellers' behaviors and, thus, make markets less than efficient. Specifically, irrational exuberance can first lead to an overpricing of securities, which in turn may lead to various drastic reactions to such mispricing, such as investors' panic selling. This happened, for example, in the stock market crash of 1929 and the bursting of the dot-com bubble at the turn of the millennium. (Peter Garber pointed out that the most famous market bubble, the 17th-century tulip mania in Holland, should actually not be regarded as an example of irrational mispricing.)

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