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Efficient Market Hypothesis was introduced by a famous
University of Chicago professor Eugene Fama in his 1970 Journal of Finance
article “Efficient Capital Markets: A Review of Theory and Empirical Work”. The
concept of efficient markets assumes that the prices of all assets fully
reflect all information that may impact their fair value. As a result, it is
impossible to outperform (to “beat”) the general market because in efficient
markets investors cannot purchase undervalued or sell overvalued assets (if
they could, the sheer volume of investors buying or selling an asset would
instantaneously adjust its value to the “fair” level). Efficient Market
Hypothesis bases its assumptions on the concept of Capital Market Line and
assumes that risk (standard deviation) and return on an asset are
interdependent. In other words, the only way for investors to increase the
return, is to assume higher risks. This assumption was arguably one of the main
reasons for the recent explosive increase in popularity of so-called ETFs
(Exchange-Traded Funds) which aim to match the performance of an industry- or
market-wide index of stocks, such as S&P 500. Because many investors assume
that attempting to outperform the market is pointless, they merely resign to at
least matching the performance of the broad market and simply buy the index.

However, despite the wide academic and theoretical
acceptance of Efficient Market Hypothesis, its viability has been widely
questioned and its popularity has been decreasing over the last decade when the
theory was widely blamed for the disastrous consequences of 2007 financial
crisis. For example, an ex-chairman of the US Federal Reserve Paul Volker has
stated that an “unjustified faith in rational expectations and market
efficiencies” was one of the reasons of the crisis. (Volker, 2011)

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However, before we can make a justifiable conclusion
about the viability of Efficient Market Hypothesis in today’s business,
economic, and financial environment, it is reasonable to first look at the
theory in detail, and also consider its criticism by the financial
practitioners and the proponents of Behavioral Finance.

First of all, in “Efficient Capital Markets: A Review
of Theory and Empirical Work” Eugene Fama differentiates three forms of
Efficient Market Hypothesis: weak form, in which market efficiency comes from
the price history, semi-strong form, in which publicly available information is
assumed to be instantaneously incorporated in asset prices, and strong form,
which concerns itself with private, or inside information. (Fama, 1970)

The basis of the weak form efficiency comes from
random walk hypothesis  – a financial
concept that states that security prices follow a random pattern and so cannot
be predicted. According to Fama, all past prices, trends, price movements and
adjustments are already incorporated in the asset price, and so technical
analysis (an approach to predicting future asset prices based on trends and
past price movements) is of no use. However, with weak form efficiency, it is
still possible to use fundamental analysis to earn excessive returns. The
followers of the weak form efficiency dismiss all market inefficiencies (such
as “Amazing January effect”) as mere anomalies.

According to the semi-strong form of market
efficiency, asset prices reflect not only all past price movements, but also
all publicly available information about present and future events (dividend
increases, mergers and acquisitions, stock splits, etc.) that can affect the
price. Hence, when some piece of information becomes public after a press
release or public announcement by corporate officials, hundreds of stock
analysts and investors around the world who follow the company will react to
the news by buying or selling the stock, which will cause the security price to
immediately adjust to the new fair value. As a result, studying company’s
quarterly and annual reports, public announcements, performing discounted cash
flow or comparable multiples analysis, or engaging in any other form of
fundamental analysis is a waste of time, since all the information that
investor can find is already fully reflected in the stock price.

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