Efficient Market Hypothesis

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Dictionary of Economics

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Efficient Market Hypothesis

What is the efficient market hypothesis?

The main idea behind the efficient market hypothesis is that the prices of traded assets already reflect all publicly available information – making it impossible to “beat the market.”

Why is that the case? Well, on average, buyers and sellers of traded assets, such as stocks, all have the same information.

Old information is already incorporated into the prices. But new information is, by definition, unexpected or random. This makes it difficult to forecast stock returns: a stock is just as likely to overperform the market as it is to underperform. With today’s technology, information travels fast and can affect the market faster than the blink of an eye. This makes the the efficient market hypothesis all the more efficient!

Want to dive deeper into these topics? Check out our Money Skills series on investing like an economist. Or take a cruise through the framework of the U.S. financial system in our Macroeconomics section on Savings, Investment, and the Financial System.

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What is the efficient-market hypothesis? The main idea behind the hypothesis is that the prices of traded assets, such as stocks, already reflect all publicly available information, and thus if you're investing based on publicly available information, you won't be able to systematically outperform the market over time.

 

Think about it this way -- on average, buyers have just as much information as sellers, and vice versa. So that means a stock is just as likely to overperform the market as it is to underperform. Stock returns are hard to forecast because old information is already incorporated in stock prices, and new information is, by definition, unexpected, or random.

 

Here's an example. At 11:39 Eastern Standard Time on January 28, 1986 the Space Shuttle Challenger exploded in a great tragedy, killing everyone on board. Eight minutes later, that news hit the Dow Jones wire service. Things were a lot slower back then before instant messaging. On that day, the stock prices of all the major contractors who had helped to build the shuttle -- such as Morton Thiokol, Lockheed, Martin Marietta, and Rockwell International -- all fell immediately by 2 to 3%, except for Morton Thiokol, whose prices fell by over 11%.

 

As it turns out, the market had correctly figured out that Morton Thiokol was the most likely cause of the disaster, and within hours that information was reflected in market prices. A formal investigation would not begin for another six months, during which time the failed O-rings made by Morton Thiokol were linked to the cause of the disaster. Now that was back in 1986. Nowadays, new information starts to change markets not in hours or minutes, but in seconds or milliseconds -- literally faster than the blink of an eye -- making the efficient-market hypothesis that much more efficient.

 

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