The efficient-market hypothesis asserts that financial markets are informationally efficient. An individual cannot significantly outperform the market on a risk adjusted basis. This implies that over a long run a trader can not expect to outperform the market, leading to some to recommend index tracking funds over other forms on investment (See a Random Walk Down Wall-Street). The efficient-market hypothesis exists in three forms:
- Weak form: prices of traded financial instruments already reflect all previous publicly available information.
- Semi Strong: prices of traded financial instruments already reflect all publicly available information and respond instantly to reflect new publicly available information.
- Stong form: adds to the claim of the semi strong hypothesis by saying prices instantly reflect hidden or insider information.
The efficient market hypothesis has received both theoretical and empirical criticism. Generally the empirical evidence for the efficient market hypothesis has been mixed, with stronger empirical evidence existing for both the weak and semi strong form of the hypothesis. Though behavioral economists have pointed to various market inefficiencies caused by combination of cognitive biases such as overconfidence, overreaction, information and representative bias.
In recent times the efficient market hypothesis and the belief in rational markets has come under criticism for what some believe it’s role in the financial crisis of the late 2000’s. From the point of view of the efficient market hypothesis, speculative bubbles represent a clear anomaly to the hypothesis which can not be explained away. Sudden market crashes of the kind that happened on Black Monday in 1987 are unexplained but are allowed by those who hold the weak form of the hypothesis as they are seen to be rare statistical event.
The efficient market hypothesis seems to be questionable on other grounds as their seems to be a number of traders and hedge funds who have continually beaten the performance of the underlying market, while over the short term this may statistically likely continued long term performance which significantly outperforms the market place starts to become highly unlikely. Other empirical evidence like the work done by Prof. Andrew Lo and Craig MacKinlay seriously undermines the efficient market hypothesis.