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The Efficient Market Hypothesis asserts that at any time the price of a stock on a stock market reflects all information about that stock and about that market, including any and all future expectations. That, in effect, "Mr. Market" knows everything before you do and in much more detail.

The basic premise of the theory is that information about every piece of information about the market has already been collected and analyzed by bazillions investors and this information is always reflected correctly in the price of any stock.

The problem with the theory's premise is that most investors (either individuals or institutional) in fact base their expectations on past prices and company performance--by analysing the historical data, or the company fundamentals.

Investor expectations control prices. Therefore, it seems that the efficient market hypothesis does not hold when past prices do have a influence on future prices.

The failure of efficient market hypothesis is bluntly empirical. A wide range of observations contradict it. Two examples suffice. (1) Most sharp movements in stock prices are unaccompanied by any new information which can adequately explain the change. (2) The Shell stock has traded at different prices for years at a time on different bourses. This latter observation contradicts not only the efficient market hypothesis, but an even more fundamental assumption of modern finance, the "no arbitrage" assumption (which is an implication of "The Law of One Price" in economics).

It is not a problem for the efficient market hypothesis that market participants rely on past information. Analysis of past information may be essential to adequately interpret new information. In any case, the efficient market hypothesis is maintained even if there are market participants who act irrationally so long as arbitrageurs who invest rationally have sufficient liquidity.

It is also not a problem for the efficient market hypothesis that some market participants make money. A problem only arises if it is possible to make money by acting on old information. This raises the question of when new information becomes old. For example, the weak form of the hypothesis holds that no publicly available information is new. The strong form requires that even insiders cannot consistently make money through their access to insider knowledge. The examples provided above violate the weak form of the hypothesis.

The first chapter of Andrei Shleifer's "Inefficient Markets, an introduction to behavioural finance" provides an outstanding overview of these issues.

The efficient market hypothesis has a weak form and a strong form. It is well known (and acknowledged) that the strong form of the efficient market hypothesis does not hold (that all known information is reflected in the trading price of a given stock at any point in time).

Weakened forms of the hypothesis are that the market tends towards the price at which all information is incorporated in the quoted price, or that shares that are traded more frequently (the BPs and Vodafones) have more information incorporated into the price, but less liquid stocks tends to be less well researched.

Whether technical analysis works as a determinant of actual future value is no longer provable, as the existance of sufficient numbers of technical analysts actively trading on the market makes it a self-fulfilling hypothesis. If sufficient numbers of traders believe a kink followed by a hop followed by increased volumes means sell, then they will all sell at once and the price will fall, thus making them the cause of their own prediction.

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