Chapter 08 – The Efficient Market Hypothesis
CHAPTER EIGHT
THE EFFICIENT MARKET HYPOTHESIS
CHAPTER OVERVIEW
This chapter examines the concept of market efficiency. We are asking whether securities are,
on average, fairly priced according to the benefits they give an investor. If they are then one
cannot expect to consistently earn more than one should for the risk level you are taking. In other
words you cannot consistently beat the market’s risk-adjusted return. There are two aspects of
efficiency, although the text does not explicitly separate the two. In an informationally-efficient
market, price changes are unpredictable. It is this aspect of efficiency with which the text is
LEARNING OBJECTIVES
After studying this chapter, the student should thoroughly understand the concept of
informational market efficiency and how to make rational investment decisions based upon the
existence of market efficiency. The student also should have a working knowledge of some tests
of market efficiency, the forms of market efficiency, and observed market anomalies. Market
efficiency is akin to the perfect competition model to which it is related. Like perfect
Chapter 08 – The Efficient Market Hypothesis
CHAPTER OUTLINE
1. Random Walks and the Efficient Market Hypothesis
PPT 8-2 through PPT 8-6
Definitions of informational and allocational efficiency are provided. Implications of efficiency
are then discussed and the idea of random walk is introduced and illustrated. Note that we
actually expect there to be a positive trend in stock prices albeit with random movements around
those positive trends. The reason that we would expect to see price changes that are random is
related to efficiency. If information that has importance for stock values arrives or occurs in a
random fashion, price changes will occur randomly. If the market is efficient in its analysis, the
change in prices will reflect that information in a timely basis.
Many students struggle with this concept so it is worth taking the time to point out the
relationships among the different forms of efficiency.
2. Implications of the EMH (for Security Analysis)
PPT 8-7 through PPT 8-10
Technical and fundamental analyses are defined in this section as well as the implications of the
different forms of market efficiency with respect to security analysis. If markets are weak-form
efficient, technical analysis, such as charting, should not result in superior profits. If markets are
3. Are Markets Efficient?
PPT 8-11 through PPT 8-22
Over time stock prices tend to follow a submartingale. This has nothing to do with efficiency,
per se. It does however have serious implications for tests of efficiency. This implies that a
randomly chosen portfolio of stocks can be expected to have a positive return. In practice this
means that when trying to figure out if some portfolio manager is earning abnormal returns we
must compare their performance to the performance of a randomly chosen portfolio. That is,
they must outperform the random portfolio or, in practice, they must beat some benchmark rate
of return. The magnitude, selection bias and lucky-event issues are covered, as well as possible
Chapter 08 – The Efficient Market Hypothesis
• It is very difficult to predict if you are in a bubble and when the bubble will burst. Stock
prices are estimates of future economic performance of the firm and these estimates can
change rapidly.
• Risk premiums can change rapidly and dramatically.
Nevertheless, with hindsight there appear to be times when stock prices decouple from intrinsic
or fundamental value, sometimes for years. What does this imply?
• Some claim the bubbles imply that investors are irrational. Perhaps, but think about what
determines the price of gold. Is it irrational to buy an asset for more than its fundamental
value if you believe that you can sell it for more than you paid for it? It is indeed risky to
engage in this type of transaction, but is it irrational?
• Bubbles seem to occur during two periods: 1) when technology is changing rapidly and
2) during periods of cheap capital when interest rates are low for extended periods. In the
first case, values will be more heavily determined by future growth prospects rather than
Some of the major types of tests that researchers have done on market efficiency are described. If
markets are inefficient, then professionals who spend considerable resources in investment
should secure superior performance. The tests are broken down in terms tests of the forms of
efficiency. Tests have uncovered some inefficiency in pricing but many possible interpretations
of results are possible. Tests of weak-form efficiency show small magnitudes of positive
4. Mutual Fund and Analyst Performance
PPT 8-23 through PPT 8-30
Some recent studies on mutual funds have documented some persistence in positive and negative