Eugene Fama Proposed the Efficient Market Hypothesis
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In 1970, Eugene Fama proposed the Efficient Market Hypothesis (EMH) in alandmark paper Efficient Capital Markets: A Review of Theory and EmpiricalWork. The fundamental idea behind the EMH is that securities markets areefficient in incorporating all information that determines the value of a security.As a result, investors cannot achieve better risk-adjusted returns than by holdingthe market portfolio. EMH has three versions. (i) The weak form of the EMHsays that the asset price fully reflects all past market price information. If theweak EMH holds, technical analysis that relies on past price actions cannotoutperform the market on a risk-adjusted basis. (ii) The semi-strong form of theEMH posits that the asset price reflects all publicly available information. If thesemi-strong EMH holds, fundamental analysis that relies on public accountinginformation is futile. (iii) The strong form of the EMH claims that the asset pricereflects all information, including all non-public information. If the strong EMHholds, no investor can outperform the market on a risk-adjusted basis.The EMH triggered an on-going debate within the academic community. Sincecorporate insiders with material non-public information can capture higher risk-adjusted returns, researchers generally agree that the strong EMH does not hold.There is no consensus on whether the weak EMH and the semi-strong EMHhold. Defenders of the weak EMH and the semi-strong EMH argue that anyinefficiency in the market will be immediately arbitraged away by smart marketparticipants. Sharpe and Alexander (1990) defined arbitrage as “the
simultaneous purchase and sale of the same, or essentially similar, security intwo different markets for advantageously different prices.” In other words, ifthere are any market anomalies—patterns in the financial market that contradictthe EMH—that produce high risk-adjusted returns, investors will immediatelyact on them and restore the market efficiency if the information is publiclyavailable. Naturally, many empirical studies by critics of the EMH arededicated to identifying market anomalies that reflect possible marketinefficiencies. In this book, we will discuss a variety of successfully identifiedanomalies. The existence of these anomalies casts serious doubt on the EMH.Besides investors’ behavioral biases and irrationality, the market structure alsocontributes to sustained mispricing of assets. For instance, there are institutionalobstacles to the dissemination of negative information about stocks. Sinceanalysts need access to senior managers of a firm to have a competitive edge ingathering information about the firm, they are more reluctant to make sell