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:: The 'Efficient Market Hypothesis' ::

Whilst reading common literature on economics and finance you will no double come across the terms 'efficient markets' and 'the efficient market hypothesis', EMT for short. The EMT states:

Market prices are the result of a large number of investors who reach decisions independently based on the same information (and, infact, based on all available information, in the strongest version of this hypothesis).

This implies market information is passed on to all investors instantaneously, so no one has an advantage over others when it comes to decisions on buying/selling. In effect, decision are solely based on ones own 'gut feeling' or opinions on future prices, which if assumed to be equally probable to buy or sell (for a large number of investors), then a random walk situation is achieved by the price dynamics. A situation where an investor has additional information (more than others) about the market is known as an arbitrage, and the investor stands to make a profit from this knowledge. Indeed, EMT is the central concept around which financial modelling is based upon. This includes the Black-Scholes model. The assumption that all available information is shared by all investors seem a gross simplifications. After all, how can an occasional investor who watches the market from time to time have the same knowledge as those working on a trading floor. On the whole, the EMT holds reasonably well in describing a generalisation of the market, in an environment which is rapidly evolving to new information and competition is fierce between investor, such that any arbitrage situations realised are quickly whipped out.

Information about the market and its propagation through the market seems be a main mechanism of price dynamics. Market prices of stock and shares are more often a reflection of the mood of investor then the actual financial performance of company. A good example would be the sky high price of internet companies that were operating on loses (e.g. lastminute.com and amazon.com), though the investors believed the future in the so called "dot-com" industry was bright. This caused stock prices to rise due to the limited number of shares (law of supply-and-demand). In this case, many investors were sharing the same information and opinion with regard to the forecast of the stock prices, rather like a herd.

Written by Alessio Farhadi

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