Efficient Market Hypothesis

Efficient market hypothesis is an investment theory that proposes that the prevailing stock prices in the market is a reflection of the available information concerning the value of the firm, thus the stock can never be undervalued or overpriced. It indicates that due to the market efficiency, the prevailing share prices will always reflect relevant information, thereby making the stocks to trade on their fair value (Beechey, Gruen & Vickery, 2000). The efficient market hypothesis opposes the notion and the move by investment managers who hold the belief that they can chose a security that will outperform the market. Investment managers are known to use different forecasting and valuation methods with an aim of outperforming the market.

It can be noted that efficient market hypothesis causes an effect where none of the relevant information is ignored, and no systematic errors are made. This causes the prices for the stock to always match the fundamentals. The consistency with the fundamentals are ascertained in the efficiency market hypothesis by offering a link on economic fundamentals and asset prices (Beechey, Gruen & Vickery, 2000).

Assumptions of the efficiency market Hypothesis

The basic assumptions of the efficient market hypothesis are that information is universally shared and that this causes stock prices to follow a random walk. This indicates that the stocks prices are affected by the news experienced today as opposed to yesterday’s trends. The weak form of the theory indicates that public market information is fully reflected in prices. The semi-strong form indicates that prices of stock are updated to represent market and non-market public information. The strong form states that the public and private information gets factored in immediately to the prices. It is clear that in all forms future price movements happens with no relation to the past stock price movements.

For a market to be considered as efficient, it needs to have; a large number of competing profit-maximizing participants who continuously analyze and value securities independent of each other, new information on securities that hit the market in a random manner, and the competing investors who always make an attempt to adjust security prices to adopt the new information (Malkiel, 2003).

Implication of Efficient Market Hypothesis for Corporate Managers

Corporate managers attempt to make investment decisions that highly favors their organization. However, the Efficient Market Hypothesis presents some challenges which affects the manner in which the corporate managers operate. One of the functions of the corporate managers affected by the EMH is the portfolio management process. This process is guided by an investment policy where the corporate managers deals with investors’ objectives and constraints. EMH points out to the corporate manager, the nature of expected returns by indicating that the portfolio management should not aim on achieving above-average returns for the investment. This indicates that the corporate manager’s role should be focused on dealing with risks as opposed to attempting to attain excess returns which is impossible in an efficient market.

Another decision by the corporate managers that is affected by the EMH is on timing of a financial policy. Some managers make the presumption that there exists a perfect time or a wrong time for issuing securities. The common notion in this is that new shares should be issued at a point in time when the market is at the top as opposed to when it at the bottom. Decisions that corporate managers tend to influence with this notion include release of financial statement and making announcements of split stocks. However, efficient market hypothesis indicates the such moves have no effect on prices because they follow a trendless random walk.

References

Beechey, M., Gruen, D., & Vickery, J. (2000). The efficient market hypothesis: a survey. Sydney: Reserve Bank of Australia, Economic Research Department.

Dobbins, R., & Witt, S. F. (1979). Some Implications of the Efficient Market Hypothesis. Managerial Finance, 5(1), 65-79.

Malkiel, B. (2003). The Efficient Market Hypothesis and Its Critics. CEPS Working Paper No. 91.