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The Controversial Efficient Market Hypothesis

6 June 2008 - Markets - Editor

The Efficient Market Hypothesis (EMH) asserts that stock market efficiency ensures that prices on traded assets – stocks, bonds and property – are a true reflection, at any given time, of all available and relevant information. This is to a great degree based on the argument that in an active market, which includes numerous intelligent and well-informed investors, stocks cannot fail to be a reflection of all available information and therefore will be appropriately priced. This being the case, according to EMH, it is impossible to use market timing or expert stock selection to outperform the overall market.

Although Efficient Market Hypothesis, where the actual price of a security is deemed to be a good estimate of its intrinsic value, continues to be a cornerstone of current financial theory, it is highly controversial and often disputed. EMH proponents argue that there is no point in searching for undervalued stocks to purchase, or to attempt to predict trends in the market either through technical or fundamental analysis - and they will present a substantial body of evidence in support of their argument.

Those who dispute the validity of the Efficient Market Hypothesis point to examples of investors who successfully beat the market over extended periods of time. A prime example of an investor who invalidates the Efficient Market Hypothesis is Warren Buffet, an American investor and businessman who in February 2008 was ranked by Forbes as the richest person in the world. Buffet adheres to the Value Investing philosophy which generally involves buying stocks which, through a form of fundamental analysis, the investor has determined are under priced at the time of purchase. Therefore, buying stocks at less than their intrinsic value is the very essence of Value Investing, something which is impossible according to the Efficient Market Hypothesis. Critics of the EMH also direct attention to the 1987 stock market crash – when the Dow Jones Industrial Average (DJIA) fell by 20 percent in a single day – as evidence that stock prices can drastically deviate from their fair values.

The majority of individuals who buy and sell stocks on the stock market do so in the belief that the stocks they are buying are worth more than the price paid, while the stocks they are selling are worth less than the asking price. How those critical buy and sell decisions are made, is very much an individual choice.

 


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