RDP 2000-01: The Efficient Market Hypothesis: A Survey 2. The Efficient Market Hypothesis

When the term ‘efficient market’ was introduced into the economics literature thirty years ago, it was defined as a market which ‘adjusts rapidly to new information’ (Fama et al 1969).

It soon became clear, however, that while rapid adjustment to new information is an important element of an efficient market, it is not the only one. A more modern definition is that asset prices in an efficient market ‘fully reflect all available information’ (Fama 1991). This implies that the market processes information rationally, in the sense that relevant information is not ignored, and systematic errors are not made. As a consequence, prices are always at levels consistent with ‘fundamentals’.

The words in this definition have been chosen carefully, but they nonetheless mask some of the subtleties inherent in defining an efficient asset market.

For one thing, this is a strong version of the hypothesis that could only be literally true if ‘all available information’ was costless to obtain. If information was instead costly, there must be a financial incentive to obtain it. But there would not be a financial incentive if the information was already ‘fully reflected’ in asset prices (Grossman and Stiglitz 1980). A weaker, but economically more realistic, version of the hypothesis is therefore that prices reflect information up to the point where the marginal benefits of acting on the information (the expected profits to be made) do not exceed the marginal costs of collecting it (Jensen 1978).

Secondly, what does it mean to say that prices are consistent with fundamentals? We must have a model to provide a link from economic fundamentals to asset prices. While there are candidate models in all asset markets that provide this link, no-one is confident that these models fully capture the link in an empirically convincing way. This is important since empirical tests of market efficiency – especially those that examine asset price returns over extended periods of time – are necessarily joint tests of market efficiency and a particular asset-price model. When the joint hypothesis is rejected, as it often is, it is logically possible that this is a consequence of deficiencies in the particular asset-price model rather than in the efficient market hypothesis. This is the ‘bad model’ problem (Fama 1991).

Finally, a comment about the word ‘efficient’. It appears that the term was originally chosen partly because it provides a link with the broader economic concept of efficiency in resource allocation. Thus, Fama began his 1970 review of the efficient market hypothesis (specifically applied to the stockmarket):

The primary role of the capital [stock] market is allocation of ownership of the economy's capital stock. In general terms, the ideal is a market in which prices provide accurate signals for resource allocation: that is, a market in which firms can make production-investment decisions, and investors can choose among the securities that represent ownership of firms' activities under the assumption that securities prices at any time ‘fully reflect’ all available information.

The link between an asset market that efficiently reflects available information (at least up to the point consistent with the cost of collecting the information) and its role in efficient resource allocation may seem natural enough. Further analysis has made it clear, however, that an informationally efficient asset market need not generate allocative or production efficiency in the economy more generally. The two concepts are distinct for reasons to do with the incompleteness of markets and the information-revealing role of prices when information is costly, and therefore valuable (Stiglitz 1981).