Essay Example on The Efficient Market Hypothesis

The Efficient Market Hypothesis is one of the most well known and influential theories in financial economics Extensive literature exists on the topic as many economists have written about the concept as well as trying to extend upon its framework The origins of the theory date back to the 1960 s nevertheless half a century later the concept is still discussed and very highly regarded which provides motivation for this essay In contrast to this theory is the Adaptive Market Hypothesis This idea provides a more extensive modern look at the EMH theory Proposed decades later the AMH aims to emerge the EMH concept with behavioural finance ideas to reform the idea that many individuals have on EMH trading strategy In this paper I will start by presenting both the EMH and AMH concepts in full Outlining the strengths and weaknesses of both I will then conduct a comparison of the two concepts to form a decision on which idea seems to be superior if any Efficient Markets Hypothesis EMH As with many economic theories and ideas of the modern day the origins of the EMH can be traced far back This theory was initially illustrated by Paul Samuelson 1965 In Samuelson s paper Proof that Properly Anticipated Prices Fluctuate Randomly he adds that in an informationally efficient market price fluctuations cannot be foreseen 

However Eugene Fama 1970 formalised this hypothesis the theory of EMH generally states that securities markets such as the stock markets are efficient in pricing reflecting all publicly available information The view was that when new market information arises the news quickly spreads and the market adjusts the security price reflecting the new found information without delay Therefore neither fundamental analysis or technical analysis bear any advantage to investors as these theories are based on information and if they security price already reflects the information then it makes them redundant Fama 1970 identified three levels and strengths which explain the efficiency of a market These three levels are strong form EMH semi strong form EMH and weak form EMH Strong form EMH states that if all relevant information is available to existing and potential investors and this information is then in turn reflected in the share price then the market is efficient For example if the market price is valued lower than it should be as there is privately held information the holders of the private information will exploit this by buying shares They will continue to do so until the driving up the price to which they believe the shares to be worth supported by the information At this point they will sell their shares and withdraw from the market with a profit This is an example of strong form EMH In theory this is the most ideal form of EMH for investors The semi strong form EMH theory says where all publicly available information is reflected in the market price a market is efficient This practically appears to make more sense of an efficient market It is thought that markets will quickly mirror the publication of new information and set a new equilibrium price Semi strong form EMH has practical significance over strong form EMH as it can be more practically observed and tested Weak form EMH is strongly allied with the Random Walk Theory This theory was a term coined by Burton G Malkiel simply put the theory states that securities prices are completely random therefore are not influenced by any past events 

The central idea behind this theory is that the randomness of security prices purifies markets such that finding price patterns and taking advantage of new information becomes redundant Due to this all known information is fully reflected in prices Therefore uninformed investors can obtain a rate of return similar to returns achieved by investing experts Adaptive Market Hypothesis AMH The AMH model as proposed by Andrew Lo 2004 is an attempt to extend upon on and merge the EMH model with behavioural economics The AMH model emphasises the apparent irrationality of markets as a rational reaction to a change in environmental conditions AMH is based on biological evolutions such as competition learning and adaptation More generally the theory is about market conditions being based somewhat on imperfect individual perceptions of how recent changes may or may not affect future asset prices Despite the qualitative nature of this hypothesis AMH offers strong implications for the practice of portfolio management the core principles of this theory consist of 1 individuals act in their own self interest 2 individuals make mistakes 3 individuals learn and adapt 4 competition drives adaptation and innovation 5 natural selection shapes market ecology 6 evolution determines market dynamics It is implied that the market efficiency is based on evolutionary principles and environmental factors such as the number of competitors in a market and the able of market participants to adapt to the market conditions According to Lo 2004 the AMH can be viewed as an alternative to EMH derived from evolutionary principles Under the AMH investment strategies will be cycle through periods of profits and losses as a result of changing market conditions changing number of competitors entering and exiting the market and the extent of profitable opportunities As these opportunities change so do the affected populations The AMH has specific implications The first is that opposed to EMH there are few arbitrage opportunities as the absence of these opportunities would leave no incentive to gather information on security prices However as investors use these opportunities they disappear