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Modern Portfolio Theory and Investment Analysis, 9th Edition by William N. Goetzmann, Stephen J. Brown, Martin J. Gruber, Edwin J. Elton

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17

Efficient Markets

The Efficient Market Hypothesis (EMH) is a theory that the price of a security reflects all currently available information about its economic value. A market in which prices fully reflect all available information is said to be efficient. The concept is important for investment management because it serves as a guide to expectations about the potential for profitable trading, the likelihood of finding an investment manager who can beat the market, and the limits of predictability in the capital markets. If the theory is precisely true, it is impossible for a speculator, an investment manager, or the clients of the manager to consistently beat the market.

The intuition underlying the EMH is the invisible hand of the marketplace. In a quest for profits, competition among speculators to buy undervalued assets or sell overvalued assets will quickly drive expected gains to trade to zero. The statement that prices “reflect all available information” implies that no trader has any kind of informational advantage in the security markets. If this is so, then the price today reflects the common or “market” expectation of what the security would be worth tomorrow.

The formal theoretical expressions of the EMH actually do not imply that prices are set in some kind of competitive market equilibrium. Nor do they specify the mechanism by which prices “reflect all available information.” More significantly, the theory does not imply that market prices are “right,” or that ...

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