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Efficient Market Hypothesis

The efficient-market hypothesis (EMH) is a fundamental concept in financial economics that posits that asset prices reflect all available information, making it impossible to consistently "beat the market" on a risk-adjusted basis. ## Overview The efficient-market hypothesis (EMH) is a cornerstone of modern financial economics, providing a framework for understanding how asset prices are determined in financial markets. At its core, the EMH states that asset prices reflect all available information, both past and present. This implies that market prices should only react to new information, and that it is impossible to consistently achieve returns in excess of the market's average return on a risk-adjusted basis. The EMH is often associated with Eugene Fama, who, in his 1970 review of the theoretical and empirical research, provided a comprehensive framework for understanding the concept. The EMH has far-reaching implications for investors, policymakers, and financial professionals. It suggests that attempting to time the market or pick individual stocks that will outperform the market is a futile endeavor. Instead, investors should focus on diversifying their portfolios and taking on risk in a manner that is consistent with their individual risk tolerance. The EMH also has implications for financial regulation, as it suggests that markets are self-correcting and that government intervention may not be necessary to prevent market crashes or bubbles. ## History/Background The idea that financial market returns are difficult to predict dates back to the early 20th century, with the work of Louis Bachelier, Benoit Mandelbrot, and Paul Samuelson. However, it was Eugene Fama who, in the 1960s and 1970s, developed the EMH into a comprehensive framework for understanding financial markets. Fama's work built on the earlier research of Harry Markowitz, who had developed the modern portfolio theory (MPT) in the 1950s. The MPT posits that investors should diversify their portfolios to minimize risk, while the EMH suggests that markets are efficient and that it is impossible to consistently achieve returns in excess of the market's average return. ## Key Information The EMH is often formulated in three forms: 1. **Weak form**: This form of the EMH states that past market data cannot be used to consistently achieve returns in excess of the market's average return. 2. **Semi-strong form**: This form of the EMH states that all publicly available information cannot be used to consistently achieve returns in excess of the market's average return. 3. **Strong form**: This form of the EMH states that all information, public and private, cannot be used to consistently achieve returns in excess of the market's average return. The EMH provides the basic logic for modern risk-based theories of asset prices, such as consumption-based asset pricing and intermediary asset pricing. These frameworks combine a model of risk with the EMH to provide a comprehensive understanding of how asset prices are determined in financial markets. ## Significance The EMH has had a profound impact on the field of financial economics, shaping the way that investors, policymakers, and financial professionals think about financial markets. It has also had significant implications for financial regulation, as it suggests that markets are self-correcting and that government intervention may not be necessary to prevent market crashes or bubbles. The EMH has also been influential in the development of modern portfolio theory and other risk-based theories of asset prices. INFOBOX: - Name: Efficient Market Hypothesis - Type: Financial Economics Concept - Date: 1960s-1970s - Known For: Providing a framework for understanding how asset prices are determined in financial markets TAGS: Efficient Market Hypothesis, Financial Economics, Eugene Fama, Modern Portfolio Theory, Risk-Based Theories, Asset Pricing, Market Efficiency, Financial Markets, Investment.