The efficient market hypothesis is a theory in economic economics that says that asset prices reflect both available data and all of the information necessary for making accurate economic forecasts. A direct implication is that there’s just no way to consistently “beat the market,” either on a long-term risk-adjusted basis or on a short term one, since price fluctuations must be driven by changes in external conditions. What then does an efficient market hypothesis do?
It helps us see the benefits of using economic forecasting techniques, such as forward looking market forecasts. For example, it can help us understand why the price of an asset moves up or down over time, or what the price of an asset will look like a year or so from now. It also explains why the price of an asset will be highly correlated to the price of a commodity (i.e. how much of an asset’s price goes up or down depends on how much of an asset’s price is affected by its commodity content).
So, how do we make use of the efficient market hypothesis? One obvious application is in asset pricing, and the concept is pretty well understood. For example, if the supply of a certain asset is limited, and its price is going up in response to the scarcity, it can be said that the supply drives the price upward, while a demand-driven rise in the price of a commodity reflects the abundance of that commodity. Conversely, if the supply is plentiful and its price is falling due to the scarcity, it can be said that the abundance drives the price down, but the scarcity is driven by the same forces that caused the price to rise in the first place. These are, in a nutshell, what asset pricing is all about.
But in addition to asset pricing, the efficient market hypothesis can also be used in many other areas of economics. In fact, it’s been used to explain various economic phenomena for nearly two centuries. Let’s take a look at some examples of how this simple theory has been applied to various economic situations.
First of all, the efficient market hypothesis can be used to explain why price changes tend to be quite persistent across many different economic institutions. This can be particularly useful in explaining why central banks tend to follow very similar policies over time. Central banks have different ways of setting interest rates, and other policy parameters, but the effect of these policies tends to stay consistent over time. This consistency between different policies can be attributed to the efficient market hypothesis.
Another good example of how the efficient market hypothesis can be used in economics is to explain why certain industries tend to be more stable than others. For example, the energy industry tends to be a little bit more stable than other industries, because the resources it uses are easier to extract and transport. But, oil exploration is much harder to control and so, its price tends to fluctuate a great deal across time.
The efficient market hypothesis also has a lot to do with why people tend to buy or sell assets at different points in time. For example, most of us tend to buy when the prices of commodities are high and then sell when they’re low. However, if the prices of commodities are high and the economy’s resources are easy to extract, then people who own them tend to hold on to them instead of trading them.
It seems to be reasonable to expect that the efficient market hypothesis will prove to be important in economics in many areas, as the underlying assumption seems to be that people are the most important thing in any economic situation. This means that we’ll be able to make better use of available information to determine which factors are important, what policies will make people better off, and which variables are likely to have a significant impact on the overall performance of the economy.