The efficient markets hypothesis does not constitute a good approximation to reality, and is often violated to a substantial degree in financial markets. The efficient markets hypothesis states that the price of every stock equals the value of the stock, so no stock is a better buy than any other. The EMH says that no stock is a better buy than any other, which justifies random choices. Efficient markets theory is interconnected with the classical theory of asset prices. The classical theory states that a stock price always equals the present value of expected earnings, assuming rational expectations: expected earnings are the best possible forecasts. Thus the price of a stock always equals the best estimate of the stock's value. Undervalued stocks don't exist, so don't bother looking for them.
When people pick stocks, they try and forecast future price changes. The EMH states that the stock price reflects forecasts of earnings based on all public information. The price changes when new information arrives, changing the forecasts. If the information was anticipated, it would already be accounted for in earnings forecasts. Obviously, one can't predict surprises. Since only surprises affect stock prices, changes in these prices are unpredictable and follow a random pattern.
Data supporting the efficient market hypothesis has been pointed out by most major economic texts. Many savers have the choice of investing in mutual funds, choosing between an actively managed fund and index fund. An actively managed fund employs analysts who do fundamental research, buying and selling stocks frequently based on recommendations. An index fund doesn't try to pick stocks but instead buys all the stocks in a broad market index. These funds buy stocks and then hold onto them, not making trades as often as an actively managed fund. An EMH supporter would obviously support an index fund, believing that the actively managed fund couldn't consistently beat the market.
According to our text, about 1300 actively managed stock funds operated over the decade 1995-2005. Averaging these funds together, the rate of return was 8.2; the return on the S&P 500 was 10.0. Of the individual mutual funds, 15% had a higher return than the S&P 500. EMH supporters believe this success can be explained by luck. Different funds buy different sets of stocks. Over any period, financial news about companies will cause some stocks to perform better than others. Mutual funds that happen to own these stocks will have above-average returns. Research studies have shown that mutual funds with above-average returns over periods of 1 to 5 years show that these funds won't beat an index in subsequent years.
There are a few reasons to believe that the efficient market hypothesis is violated to a substantial degree in financial markets. Let's start by examining fast traders.
[...] Obviously the efficient market hypothesis has serious flaws in it that can be exploited in a variety of ways. According to classical Keynesian theory, money supply has effects on prices and output through the nominal interest rate. By increasing the money supply, the interest rate is reduced according to the money demand equation. Lower interest rates stimulate overall output and spending. A “zero bound” exists for the nominal interest rate. No will lend money if they receive less than that amount back. [...]
[...] This lax monetary policy fueled excessive credit growth, creating the potential for financial instability. If the Fed had raised interest rates more quickly, the excessive credit growth that fueled the subprime mortgage boom could have been curbed to a stable level. Last but certainly not least, if regulators had limited the amount of leverage available to banks, much of this crisis could have been mitigated. Banks had been incentivized to invest in the same assets that produced high returns. Even if it was risky, if everyone did it then you could just blame the system rather than your poor judgment. [...]
[...] This default caused people to wonder what other firms could default, no firm being deemed as completely safe. Keeping Lehman Brothers solvent may have mitigated the spread of this panic by restoring some confidence and keeping liquidity somewhat available in a time of dire need. Much of the increase in demand before the crisis was caused my large capital inflows coming into the United States. Deemed the “global savings glut” by Ben Bernanke, the United States had a low savings rate that worsened the crisis. [...]
[...] There are a few reasons to believe that the efficient market hypothesis is violated to a substantial degree in financial markets. Let's start with examining fast traders. The logic behind the EMH is that if there is good news about a company's earnings, demand rises for the company's stock. Higher demand obviously pushes the stock price higher, reflecting current expectations about earnings. The EMH assumes that stock prices are immediately responsive to surprise news. In reality, these price adjustments take a little time. [...]
[...] Using the Euro doesn't allow Greece to have control over its own monetary policy. Devaluation would make Greece's domestic goods cheaper compared to the same goods from other countries. This would increase the amount of capital inflows, allowing the economy to grow. Greece is in this problem due to systemic fraud. Greece ran large cyclical deficits, spending more than their means. As the global finance crisis spread, tourism and shipping revenues fell more than 15% after the crisis. In May 2010, the Greek deficit was estimated to be the highest in the world. [...]
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