2  The efficient markets hypothesis

The efficient markets hypothesis states that, if markets are efficient, then asset prices should reflect all available information. As such, prices should reflect the fundamental value of the asset.

When Eugene Fama (1970) first labelled the efficient markets hypothesis, he proposed three forms of market efficiency:

Practically, there is a cost to acquiring information, so the assumption that prices will always reflect all information is not reasonable. Therefore, a better working definition for the efficient market hypothesis is that prices reflect all information except that for which the marginal cost of acquiring the information exceeds the marginal benefit of acting on the information.

This last statement implies that, although there may be some information not yet incorporated into the price, no investor can generate excess returns. For example, when Malkiel (2005) examined mutual fund performance versus the S&P 500 index, around three quarters of funds underperformed on an annual basis and over 80% underperformed over 10-year periods. Similarly, in an analysis of household trading from 1991 to 1996, Barber and Odean (2000) found that the average household earns an annual return of 16.4 percent compared to a market return of 17.9 percent.

The efficient markets hypothesis is largely examined and tested using data from exchanges. The high levels of liquidity and the transparency of prices and dividends allow minute examination of whether the price is efficient. As we will see, however, determining whether a market is efficient is not an easy task.