The Ef cient Market Hypothesis and Its Critics

A generation ago, the efŽ cient market hypothesis was widely accepted by academic Ž nancial economists; for example, see Eugene Fama’s (1970) in uential survey article, “EfŽ cient Capital Markets.” It was generally believed that securities markets were extremely efŽ cient in re ecting information about individual stocks and about the stock market as a whole. The accepted view was that when information arises, the news spreads very quickly and is incorporated into the prices of securities without delay. Thus, neither technical analysis, which is the study of past stock prices in an attempt to predict future prices, nor even fundamental analysis, which is the analysis of Ž nancial information such as company earnings and asset values to help investors select “undervalued” stocks, would enable an investor to achieve returns greater than those that could be obtained by holding a randomly selected portfolio of individual stocks, at least not with comparable risk. The efŽ cient market hypothesis is associated with the idea of a “random walk,” which is a term loosely used in the Ž nance literature to characterize a price series where all subsequent price changes represent random departures from previous prices. The logic of the random walk idea is that if the  ow of information is unimpeded and information is immediately re ected in stock prices, then tomorrow’s price change will re ect only tomorrow’s news and will be independent of the price changes today. But news is by deŽ nition unpredictable, and, thus, resulting price changes must be unpredictable and random. As a result, prices fully re ect all known information, and even uninformed investors buying a diversiŽed portfolio at the tableau of prices given by the market will obtain a rate of return as generous as that achieved by the experts.