Efficient Market Hypothesis (EMH) Theory
In practice, markets are not 100% efficient because of the following reasons.
Transaction cost exists such as commission and capital gains tax etc, which resist investors from buying or selling shares, if shareholders are not satisfied with their investment in the company.
Information is not equally available to all market participants because directors have more information than shareholders. Insider dealing law in UK aims to prevent leakage of confidential information to the public.
Not all investors participating in the market respond to situation in the same way. Investors take decisions on non-financial grounds such as feeling pride in having share in blue chip companies such as Microsoft.
Foreign investors may not have information on local conditions affecting performance of the company.
Institutional investors such as banks, insurance companies, pension funds etc are major investors in any company. Buying and selling shares by institutional investors can result in significant share price changes due to excess demand and oversupply of the company shares in the market.
Efficient market hypothesis identifies three levels of market efficiency according to the presence of characteristics of efficient market.
Weak Form Efficient
Weak form efficient market reflects all the historical information in share price. Historical information can be following:
Published financial statement represents performance for the previous year.
Past dividend payments do not reflect current performance of the organization.
Reputation is made because of performance in the past. It is not representative of current performance of the company.
Share price will change based on the outcome of new information rather than at the announcement of new information.
Technical analysis will not be useful for above average profit making. As share price is already reflecting historical information.
Semi Strong Form Efficient
Semi strong form efficient market reflects all the publicly disclosed information as well as historical information in the share price. New information disclosed by the company immediately results in increase or decrease in share price depending on perception of investors regarding new information being good or bad for shareholders wealth.
Disclosed information can be following:
- Declaration of dividend for the current year.
- Disclosure of dividend policy.
- Discloser of future cash flow forecast.
- Discloser of investment decision taken by the company.
- Discloser of financing decision taken by the company.
- Press release for accidents in the company.
- Discloser of information on misappropriation of funds.
Gathering new information and technical analysis both will not be useful for making above average profits in the semi-strong form efficient markets. As share price will already be reflecting disclosed and historical information of the organization.
Technological advancement such as internet has played a vital role in lowering cost of getting real time (up to date) information.
Corporate governance frame works emphasis on transparency and clear disclosures also resulting in semi strong form efficient markets.
In practice, most stock markets are semi strong form efficient as any rumour (information disclosed) in the market causes immediate change share price.
Strong Form Efficient
Strong form efficient market also reflects insider information in addition to disclosed and historical information. Insider information is the information, which is not disclosed to public.
Insider information can be following:
- Board of directors considering proposal for launching product or entering new market.
- Research and development team devised new formula, which is not officially disclosed.
- Directors considering declaration of current dividend in the boardroom.
Use of insider information will not be useful for above average profit making in the strong form efficient markets. As share price will already be reflecting historical, disclosed and insider information of the company.
Use and discloser of insider information for profit making is illegal and criminal offence under insider dealing act UK. It does not matter whether it results in profit or loss.
In practice, stock market is not strong form efficient as evidence dictates that profit making is possible by thorough careful market research.
