Econs: Efficient Markets Theory

Efficient markets theory/ Efficient Markets Hypothesis

Developed by Eugene Fama – states that it is impossible to beat the market since the prices already reflect and incorporate all relevant information.

Theory that all market participants receive and act on all of the relevant information as soon as it becomes available. That means that whatever information is available about a stock to one investor is also available to all investors. Since everyone has the same information about a stock, the price of a stock should reflect the knowledge and expectations of all investors.

Bottom line is that an investor should not be able to beat the market since there is no way for him to know something about the stock that isn’t already reflected in the stock’s price.

http://www.investorwords.com/1672/Efficient_Market_Theory.html

http://www.investopedia.com/university/concepts/concepts6.asp

Article: What can replace the efficient market theory? By Jonathan Davis

The Financial Times 13 July 2009

“The most interesting thing about the efficient markets theory is not whether it is valid or not – clearly it is not – but how it has managed to remain so influential for so long”

“Behavioural finance has grown to become a popular alternative approach precisely because it does appear to explain more clearly how investors individually and collectively, appear to act."

Economics trying to imitate the sciences –particularly physics.Professor Andrew Lo of MIT – mere case of “physics envy”. Nobel Laureate Paul Samuelson developed a set of fundamental laws in an attempt to do for economics what Newton’s laws of thermodynamics did for physics.

• Utility Theory : Economics concept that although it is impossible to measure the utility derived from a good or service, it is usually possible to rank the alternatives in their order of preference to the consumer. Since this choice is constrained by the price and the income of the consumer, the rational consumer will not spend money on an additional unit of good or service unless its marginal utility is at least equal to or greater than that of a unit of another good or service. Therefore, the price of a good or service is related to its marginal utility and the consumer will rank his or preferences accordingly

• Equilibrium: State of stable conditions in which all significant factors remain more or less constant over a period, and there is little or no inherent tendency for change.
• Principle of no arbitrage: Prices cannot allow for risk free net profits. Underlying assumption that markets eliminate any opportunity for risk-free profits.
• Efficient markets hypothesis and notion that stock prices follow a random walk are offshoots of this approach. Problem is that the financial markets don’t lend themselves well to deductive theory.

Prof Lo:

“Economic systems involve human interactions which almost by definition are more complex than interactions of inanimate objects governed by fixed and known laws of motion”

Prof Lo’s response has been to develop an “adaptive markets hypothesis which seeks to draw on the insights of neuroscience and evolutionary biology”. The aim is to create a framework which relates the behavior of financial markets to a number of different factors, including the emotional condition of the market participants at different points in time and the current balance of advantage between competing groups of market participants. Believes that what is at work in the financial markets is a Darwinian process of “survival of the richest”.

Implications of this approach:-

• Relationship between risk and return will not be stable over time
• Rather than markets becoming steadily more efficient, this world is one in which new profit opportunities will continue to emerge at a constant rate.
• Does not give investors (unlike the efficient markets theory) a simple metric for understanding what to do.

BUT it does appear to relate to the complex/mutable world we live in which the efficient markets hypothesis does not do.