Finance 101: The Efficient Market Hypothesis' Impact on Financial Markets

When we think of financial markets we think of Wall Street, Dow Jones Industrial Average, and the New York Stock Exchange. Just twenty years ago the floors of Wall Street were littered with traders screaming and shouting at each other trying to trade little pieces of paper called stocks. There would be countless of people phoning in information, and based on that information prices would fluctuate as quick as people could trade.

Nowadays, things are much different. There are no longer traders littering the floor, no longer pieces of paper being traded back and forth, and no longer people shouting and screaming at each other for hours on end. What caused this drastic change within the past twenty years? One simple concept - the desire to be the first to receive and respond to information.

Initially, the change began when trading began to be automated. One of the leading firms with this was Goldman Sachs. Their firm began utilizing computers to execute trades faster than their competition. Soon the competition caught on, and automation became the driving force of the industry. Recently a new idea has caught on involving computers, machine learning. Through machine learning, computers are performing analysis to find trends in the market, as well as scanning news websites to react instantaneously to news. It has even gotten to the point where computers analyze words and phrases that are present in recent news articles and execute trades based on that information. This is the essence of the Efficient Market Hypothesis.

The Efficient Market Hypothesis

The Efficient Market Hypothesis is the concept that the market reacts instantaneously to information. This means that the price will be updated instantaneously to reflect whatever news is available to the market. This even includes information in the future that is only rumored or expected.

When the market was younger, traders were able to obtain edges. An edge is an advantage in the market as compared to other traders. The old lag in the information becoming available to the trades being executed is what fueled the desire to be on the floor and as close to the action as possible. As automation continues to develop, these edges begin to disappear and give way to the efficient market hypothesis.

There are three forms of the efficient market hypothesis, which are based on opportunities to gain edges in the market. These three forms are weak, semi-strong and strong.

Weak form

The weak form of the efficient market hypothesis states that all the currently available market information is already factored into the price. No historical information can be used to gain an edge, because everything that is public is already factored into the price.

Semi-strong form

The semi-strong form of the efficient market hypothesis states that all information relating to the stock has already been factored into the price and will be factored into the price when available. This expands on the weak form to include fundamental information about the company, and where they may be headed in the future. Say for example that a company is expected to obtain a new patent. With the semi-strong form of the efficient market hypothesis, the market will calculate an expected impact on the price and adjust to reflect this. Then, when that hypothesis is either confirmed or denied, the market will react nearly instantaneously to reflect the news.

Strong form

Lastly, we have the strong form of the efficient market hypothesis. With this form, the market would instantaneously react to all new information, and have already factored in all public and non-public information. This can include insider information and basically assumes a perfect market. With this hypothesis it would be impossible to gain any edge and investments would be purely based on chance.

Where do you stand?

Now that you see the basics of the efficient market hypothesis, it's important to analyze how it may impact your investments and trades. I often hear people say "The new iphone 8 is coming out. Obviously the price is going to go up when it's released!" This may occur, but I contend that it is likely already factored into the price. I believe that this is especially true with established and reoccurring events like iphone releases.

Personally, I see myself as a day and swing trader more than a long-term investor. With this in mind, I believe in the ability of being able to perform technical analysis on historical prices to obtain a better than 50% chance of predicting future price movements. This contends even the weak form of the efficient market hypothesis.

At the same time, I also believe that all information that hits the major markets is reflected nearly instantaneously in the prices. When you look at charts in the real market, as news comes out about a company, you will see a vertical line in the stock price. I believe that some of the early human investors may have an opportunity to gain some return on this information within the first few seconds to possibly minutes, but the majority of the profit will already be consumed by automation.

As an investor, understanding the efficient market hypothesis could help prevent you from experiencing large losses. It is important to think about what information is already factored into the price, and not get caught up in the hype and expectation that future prices will increase.

As always, this post is not investment advice and should not be used in any investment decisions. I am not a licensed adviser, but rather am providing my own views on the above material for discussion purposes. You should never base your investments off someone else, and instead should do your own research.

I hope that you found this post interesting. If you have any questions, please comment below. My goal with this profile is to make frequent posts about finance, cryptocurrencies, investment, and wealth generation. I plan to not only make posts, but also youtube videos, and give away free excel workbooks to assist you in your personal finance goals. If this interests you, please let me know and follow my profile. Additionally, if you would like to reach out and ask any questions/request that I make a post on a topic, please reach out to me at [email protected].