The efficient market hypothesis stipulates that an investor can not consistently make abnormal risk-adjusted returns from trading the market. The theory explains that a stock is efficient if the following three criteria hold:
1. The share price reflects all relevant information
2. The share price adjusts rapidly to new information
3. The share price is an unbiased estimate of it’s true value
The premises of an efficient market are:
1. A large number of competiting profit-maximizing participants who analyze and value securities independtly of each other
2. New information regarding securities comes into the market in a random fashion
3. Profit maximizing investors adjust the share price rapidly to reflect the effect of new information
If we look at the stock market, we have thousands of investors globally that react almost instantaneously to any new piece of information. Investors have different analysing techniques (fundamental, technical, multiples approach etc) as well many assumtptions. Finally with the internet, instant access to news and even a business TV channel (CNBC) information is plentiful. We could therefore conclude that there is strong evidence to support this theory.
However academics are divided in regards to how efficient the market really is. The efficient market hypothesis is divided into three categories:
Weak form efficiency: In a weak-form efficient market the current share price should reflect all relevant historical information such as past prices, volume, PE ratio etc. For this reason future stock prices are unpredictable and the stock should follow a random walk. Following this idea, if we were to look at a chart of a stock it should be just as random and variable as simply tossing a coin. Furthermore technical analysis (which uses past stock price information to predict subsequent price changes) would be useless