Summary: The Efficient Market Hypothesis (EMH) emerged from empirical studies suggesting that asset prices follow a random walk. Early studies by Bachelier, Working, Cowles, and Kendall showed no correlation between successive price changes, indicating that markets did not follow predictable patterns. Samuelson and Mandelbrot later developed the EMH, arguing that if markets function properly, all public (and sometimes private) information is immediately reflected in asset prices. This means that price changes appear random because investors have already exploited all arbitrage opportunities. The concept gained prominence through Eugene Fama’s work in 1970 and was linked to the rational expectations hypothesis in macroeconomics. While the EMH presented challenges for technical traders and chartists, who believed they could predict price movements, it also acknowledged the possibility of speculative bubbles driven by misinformation or crowd behavior. However, the hypothesis primarily emphasizes the role of information and beliefs in market efficiency, rather than addressing other forms of economic efficiency like resource allocation.
The second important strand of work on finance was the empirical analysis of asset prices. A particularly disturbing finding was that it seemed that prices tended to follow a random walk. More specifically, as documented already by Louis Bachelier (1900) (for commodity prices) and later confirmed in further studies by Holbrook Working (1934) (for a variety of price series), Alfred Cowles (1933, 1937) (for American stock prices) and Maurice G. Kendall (1953) (for British stock and commodity prices), it seemed as there was no correlation between successive price changes on asset markets.
The great breakthrough was due to Paul A. Samuelson (1965) and Benoit Mandelbrot (1966). Far from proving that financial markets did not work according to the laws of economics, Samuelson interpreted the Working-Cowles-Kendall findings as saying that they worked all too well! The basic notion was simple: if price changes were not random (and thus forecastable), then any profit-hungry arbitrageur can easily make appropriate purchases and sales of assets to exploit this. Samuelson and Mandelbrot thus posited the celebrated “Efficient Market Hypothesis” (EMH): namely, if markets are working properly, then all public (and, in some versions, private) information regarding an asset will be channelled immediately into its price. (note that the term “efficient”, as it is used here, merely means that agents are making full use of the information available to them; it says nothing about other types of “economic efficiency”, e.g. efficiency in the allocation of resources in production, etc.). If price changes seem random and thus unforecastable it is because investors are doing their jobs: all arbitrage opportunities have already been exploited to the extent to which they can be.
The “Efficient Markets Hypothesis” was made famous by Eugene Fama (1970) and later connected to the rational expectations hypothesis of New Classical macroeconomics. It did not please many practioners. “Technical” traders or “chartists” who believed they could forecast asset prices by examining the patterns of price movements were confounded: the EMH told them that they could not “beat the market” because any available information would already be incorporated in the price. It also had the potential to annoy some fundamentalist practioners: the idea of efficient markets rests on “information” and “beliefs”, and thus does not, at least in principle, rule out the possibility of speculative bubbles based on rumor, wrong information and the “madness of crowds”.
Author Bio
