Essay: The validity of the efficient market hypothesis (EMH)

The validity of the efficient market hypothesis (EMH) remains intact despite critics’ claims of responsibility for the 2007-2008 financial crisis by reaffirming its random walk principles and dismantling expectations of prediction. The model’s explanation of current prices reflecting all available information demonstrates an efficient market, arguably working toward the prevention of an asset bubble through investor’s acceptance of these prices. Instead of causing the financial crisis, strict adherence to EMH principles could have helped prevent the crisis from occuring.
To critically assess argued implications of a financial crisis, one must understand the EMH. Introduced in 1965, this hypothesis argues that the market represents all available information when determining security prices. Unpacking this statement, the EMH merges two claims. First, the theory contains the notion that competition ensures correspondence between costs and revenues; excessive profits are eliminated or reduced by new entry. Second, asset price change is explained as a function of marketplace information flow, producing accurate prices reflecting all available information. (Ball, 2009)
This notion argues that an efficient market is one that displays the financial realities of the economy. The EMH is associated with random walk principles. This model explains that the assumption claiming a security’s current price reflects available information implies successive price changes or returns are independent. (Fama, 1970) Essentially, tomorrow’s prices will only reflect tomorrow’s information, existing independent of today’s prices. For a quantitative example, one can examine shares of a hypothetical soda company. If this company, today’s shares priced at $6, releases an incredibly successful new flavour of soda tomorrow that will place the price at $9, the share price will immediately increase to $9 rather than over the next few days.
These concepts constituting the efficient markets hypothesis devalue the usefulness of analysis. If the security price reflects all current information, analysis of future stocks is futile; stocks are unpredictable before being presented in current time. Technical analysis that uses past prices to determine future prices and fundamental analysis that uses information to identify undervalued stocks is futile in the EMH. At the most basic level, these assumptions mean that an investor would achieve equal returns from a random portfolio as a carefully selected portfolio of equal risk. (Malkiel, 2003) For a generalised model, the EMH means that ‘a market is efficient with respect to information set ϴ if it is impossible to make economic profits by trading on the basis of information set ϴ’. (Jensen, 1978) Every investor benefits from the knowledge of the price because all information is reflected, meaning extra analysis does lead to advantages.
Critics of the EMH implicate the hypothesis with the 2007-2008 financial crisis and challenge the model’s validity. In particular, these claims of invalidity are presented as a result of the ineffectiveness of analysis discussed earlier; this lack of analysis supposedly led to the asset price bubble’s undetected nature and underestimation. Investors felt no need to investigate trade securities’ actual values, leaving the market vulnerable to a crisis. Critics claim that the EMH’s prevalence is responsible for the asset bubble and miscalculation of risk, labelling the EMH a dangerous and invalid financial model. (Ball, 2009)
Defending the validity of the EMH, one can challenge the premise of the accusations placed against the model. If critics want to label the EMH as responsible for the asset price bubble creation and the 2007-2008 crisis, these individuals should consult the theory’s history. Introduced by Eugene Fama in 1965, the EMH is part of modern financial economic theory; yet, large price inflation followed by atypical, extreme drops that describe a bubble has occurred throughout organized market history. One may cite the collapse of 1929 or the 1840s ‘Railway Mania’ as examples of bubble bursts taking place before the acceptance of the EMH. (Ball, 2009) Bubbles and financial crises are not a modern, new phenomenon; the individuals questioning the validity of the EMH do not support their claims with history.
At another level, accepting EMH in a stricter sense could have aided in preventing the 2007-2008 bubble. The EMH encourages financial scepticism about ‘sure-thing’ investments, a major contributor to the crisis. Investors should have been suspicious of the bond salesman claiming the investor would receive high rewards at almost no risk on a subprime investment vehicle, especially regarding mortgages. (Hartford, 2011) Instead, investors embraced the apparently low-risk, high reward claims and developed the bubble in direct opposition to EMH principles.
In the same vein, the 2007-2008 bubble formed through assumptions of incorrect prices. From an EMH perspective, those prices reflected all available inforion to the market; yet, investors heavily invested in asset markets with believing prices would continue to rise. If investors accepted the random walk model, they would have understood that future prices are not related to current prices. Investors would not have bid the current asset prices as high as in 2007-2008 if they viewed the prices as correct, potentially averting crisis. (Ball, 2009)
Critics claiming the EMH should have predicted the crisis of 2007-2008 have not fully researched the theory. At no point does the model make any claims to predict crises; truly, the hypothesis claims the opposite. If a market crash were predictable, current market prices would be considered inefficient because they would not reflect any information contained in this prediction. (Ball, 2009) This critique of the validity of the EMH is paradoxical, as the ability to accurately predict a market crash or bubble means current prices would reflect that information.
Although the EMH has been at the discussion’s forefront regarding causes of the 2007-2008 crisis, many individuals are misguided in their criticism. Deeper understanding of economic history demonstrates the occurrence of bubbles before the introduction of the EMH. A stricter adherence to EMH principles could have helped avert the crisis. The claim that the model should have predicted the crisis misunderstands the model’s intentions. Although the EMH came under criticism as the cause of the 2007-2008 financial crisis, the theory’s validity holds firm by dismantling the criticisms and presenting a financial model that could potentially help prevent future crises from occurring.