How does insider trading affect market efficiency? – According to the efficient market hypothesis, it is not possible. We look at this famous financial theory, what it means for investors, and whether it really stands up to criticism.
What is the efficient market hypothesis?
The Efficient Market Hypothesis (EMH) is an economic and investment theory that attempts to explain how financial markets move. It industrialized in the 1960s by the economist Eugene Fama, who declared that the prices of all securities are fair and reflect an asset’s intrinsic value at any given time.
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When we talk about efficient markets, we describe a situation in which all the decisions of the market participants are entirely rational and take into account all the available information. The EMH believes this to true and states that the market price will always be completely accurate, as all new information will be valued immediately.
The EMH argues that the only volatile moves occur after unexpected news but that efficient markets resume once the information digested.
Following this theory, it would be impossible for individual investors and fund managers to “beat” the market, which is the phrase used to describe earning returns above the market average. This is because there would be no such thing as an overvalued or undervalued stock. The EMH, in its most potent form, renders fundamental and technical analysis utterly devoid of purpose, as no information can produce above-average returns other than insider trading.
For this reason, the EMH is highly controversial, and while it has many supporters, it also faces a great deal of criticism.
What are the versions of the efficient market hypothesis?
There are three different versions of the efficient market hypothesis:
How do investors and traders view efficient markets?
The way a trader or investor views efficient markets and the EMH theory will depend entirely on their view of whether an individual or a fund is capable of beating the stock market. This discussion focuses on passive and active investing and trading.
Passive investors will tend to support the EMH and focus on index funds or exchange-traded funds (ETFs) that simply mirror the underlying, offering the same benefits as the broader market. Investors and traders who believe in the EMH believe that the only way to earn more than the underlying market is to accept excessive risk. They do not try to exceed average returns or commit to taking risks. They do not try to exceed average returns or commit to taking risks.
These people are less likely to invest through fund managers as they don’t believe they can outperform the market. However, this also means that investors consistently beat the market to become famous.
Critics of the EMH are usually active investors or speculators who believe it is possible to beat the market average because there are inefficiencies in the financial markets. These participants often do not focus on funds at all, preferring to trade the individual shares of companies.
These include technical investors, who focus on short-term patterns and historical prices, and fundamental investors, who use public information and analysis to identify oversold and overbought stocks. They would take advantage of the characteristics of efficient markets by investing in stocks or ETFs or using derivative products such as CFDs to speculate on rising and falling markets.
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The defenders of the EMH
After Fama published the EMH in the 1960s, this hypothesis remained very popular in economic and business studies, and most research supported the EMH assumptions.
Even today, there continue to be arguments in favour of EMH, including:
- The superior performance of passive funds
- The presence of arbitrage opportunities
The outstanding performance of passive funds
The growing popularity of passive investing through mutual funds and ETFs are often cited as proof that people support EMH. In theory, if the EMH is wrong and the markets are inefficient, active funds should outperform passive ones. However, this is usually not the case for an extended period.
A study by Morningstar found that in the ten years ending June 2019, only 23% of active funds outperformed their passive counterparts. 1 Proponent of the EMH cites this study, as well as others like it, as evidence that markets are efficient and that, in the long run, the EMH holds.
The presence of arbitrage opportunities
Another argument in favour of the EMH is the presence of arbitrageurs. These people buy an asset in one market and sell it in another to take advantage of price differences. Arbitrageurs will look for an investment whose price does not correspond to expectations and return it to its actual value, capitalizing on the market movement as it occurs.
Using an extended position as an example, these arbitrageurs would identify stocks trading below their actual value to “buy low and sell high.” It is these investors who drive the asset towards its fundamental value.
This strategy underpins the EMH theory, as it relies on individuals to ensure that market prices accurately reflect available information.
Bubbles and market crashes
Speculative bubbles occur when the price of an asset rises beyond its fair value to such an extent that when the market corrects, prices fall rapidly, and a financial collapse ensues.
According to the efficient market premise, market bubbles and financial failures should not occur. In fact, the theory would argue that they cannot exist since the price of an asset is always exact.
For example, Fama argued that the 2008 financial crisis resulted from an impending recession and not a credit bubble. From his point of view, it could not be a speculative bubble, since it could have been predicted instead of appreciated only in hindsight.
Market anomalies describe a state in which there is a difference between the price trajectory of a stock defined by the EMH and its actual behaviour. In practice, efficient markets are almost impossible to maintain, and the presence of anomalies indicates this.
Market anomalies occur for different reasons, at other times, and have other effects. But they all show that markets are not always efficient, and individuals do not always act rationally.
If markets were truly rational, calendar-related anomalies like the January effect would not exist because there is no real explanation for them other than people’s beliefs that they will occur. In a sense, they are a self-fulfilling prophecy.
The introduction of behavioural economics has also used to criticize the EMH. The idea that market participants , in general, rational has increasingly challenged as we learn more and more about the psychology of trading.
Behavioural economics also explains, to some extent, the market anomalies described above. Social pressures can cause people to make irrational decisions, which can cause investors to make mistakes and take on a more significant amount of risk than they otherwise would. Primarily the phenomenon of herding or “herding”, which describes individuals “jumping on the bandwagon”, proves that not all decisions are rational and based on information.
Investors have compressed the market
Some investors have reliably beaten the middle market. Of course, the most well-known is Warren Buffett; his company From him Berkshire Hathaway outperformed the S&P index 73% of the time between 2008 and 2018.
Buffett does not believe in the EMH and has publicly criticized the passive approach to investing. Instead, Buffett uses a value investing method to identify undervalued stocks through fundamental analysis.
Buffett admits that the EMH makes a compelling argument and understandably drives many investors to index funds and ETFs. Buffett himself has never invested in a directory fund.