The efficient market hypothesis

A company announces a surprise takeover bid on Monday morning. By the time most investors have read the news, the share price has already jumped. Was the market quick, or did someone know first? How fast and how fully prices absorb information is the question behind the efficient market hypothesis.

The answer decides whether charts, accounts or inside tips can ever beat the market, and whether a company gains from timing a share issue or dressing up its results.

This topic covers four types of market efficiency, the weak, semi-strong and strong forms, random walk theory and chartism, insider dealing, the implications of efficiency for companies and investors, evidence, factors that affect efficiency, and behavioural finance as the challenge to the hypothesis. The previous topic covered the valuation of debt and preference shares. The next covers value-based management. The May 2014 and November 2014 Pathfinder papers both tested the hypothesis.

Key terms in plain English

Syllabus check

This topic is in syllabus area B (business analysis). It covers:

• the efficient market hypothesis and practical considerations in the valuation of shares.

CAMA 2020 and market information

The Companies and Allied Matters Act 2020 (CAMA 2020) is the company law of Nigeria.

Directors who trade on inside information may also breach their fiduciary duties and securities law. Insider dealing in Nigeria is covered by the Investments and Securities Act 2025.

The efficiency of a capital market

Investors want to be sure that the price they pay is fair. That needs the market to process information quickly and investors to have access to it. There are four types of efficiency:

• Operational: transaction costs are low enough not to deter trading.
• Informational: information about companies is processed and made available to investors.
• Pricing: investors react quickly to new information, so prices fairly reflect it. This needs operational and informational efficiency as well.
• Allocational: funds go to their most productive use. It follows from pricing efficiency.

Research focuses on pricing efficiency. In an efficient market, investors are informed at the same time, so insiders cannot profit at others’ expense.

The three forms

Weak form

Prices reflect all historical information, including past prices. Past trends cannot predict future movements. The next move is as likely to be up as down. This matches the random walk theory: prices move randomly in response to favourable or unfavourable news. It opposes chartists, who believe past patterns repeat. Chartism has no rational justification.

Semi-strong form

Prices reflect all publicly available information as well as historical information. Prices move when information is published, not before. Unconfirmed rumours should not move them, but an official bid announcement does. Inside information remains an advantage: someone who knows before the public can trade profitably. Doing so is insider dealing, illegal in countries with well-established markets.

Strong form

Prices reflect all relevant information as soon as it exists, public or private. No one can profit from inside information because the market already knows it.

1. Strong form: the price rises on 1 October, by the full ₦125m, as soon as the decision is made.
2. Semi-strong form: the price rises on 1 December, when the information becomes public. Between the two dates the information is inside information.
3. Weak form: the announcement has no effect. The price responds only as each year’s profits are published.

Evidence and practical factors

Research suggests that most markets show weak-form efficiency and that some well-developed markets, such as the New York and London stock exchanges, are semi-strong form efficient. Factors that affect efficiency:

• Marketability and liquidity: more trading gives more chances for information to be reflected.
• Availability of information: not all information reaches all investors at once. Shares followed by professional dealers are more likely to reflect it.
• Pricing anomalies: for example investor behaviour at the end of the tax year.

Implications of efficiency

If a market is strongly efficient:

• prices are fair at all times, so there is no good or bad time to issue shares or bonds;
• companies gain nothing from manipulating results, because investors see through it;
• investors will never find bargains or over-priced shares;
• a new positive-NPV project raises the share price by the amount of its NPV.

For investors: in a weak-form efficient market, technical analysis (charting) is pointless. In a semi-strong market, fundamental analysis based on public information cannot beat the market either, because the information is already priced.

Portfolio managers in an efficient market should release information about their activities (good news is quickly reflected), should not wait for a depressed price to recover, and should not waste time looking for excess returns from past or public information; only information not yet known to the public can give an above-average return.

Behavioural finance

Behavioural finance offers an alternative view, that psychological factors can make investors irrational and drive share price movements. Tendencies include:

• Overconfidence: overestimating trading skill and the accuracy of forecasts; successes are credited to skill and failures to bad luck.
• Representativeness: judging from one similar case and ignoring other evidence, such as comparing a fall with the 1929 crash.
• Narrow framing: looking at one share and not the whole portfolio.
• Miscalculating probabilities: putting too low a chance on likely outcomes and too high on unlikely ones, which can help explain bubbles; a preference for the familiar over overseas shares.
• Positive feedback and extrapolation: buying after a rise and selling after a fall, which can create bubbles.
• Cognitive dissonance: holding a belief against the evidence, which contributes to post-earnings announcement drift.
• Availability bias: being swayed by the freshest or most prominent fact.
• Conservatism: being slow to change an opinion, so one earnings surprise tends to be followed by another.

Investors are best seen as flawed rational thinkers, not wholly irrational ones.

The rules in more depth

Why a random walk is consistent with efficiency

If prices already reflect what is known, only new information can move them, and new information is unpredictable.

Why insider dealing is possible only below the strong form

If prices already reflected private information, there would be nothing for an insider to exploit.

Why efficiency matters to financial managers

It means the share price is a fair guide to the market’s view of decisions, so maximising NPV maximises the share price.

Why behavioural finance challenges the hypothesis

Persistent biases and slow reactions imply that prices can differ from fair values for a time.

Effect on analysis

State the form, describe what is reflected in prices, give the implication and mention the empirical evidence.

Worked examples

1. Strong form: price rises on 1 March.
2. Semi-strong form: price rises on 1 May.
3. Weak form: the price rises only as the profits are published later.

1. In a weak-form efficient market, past prices are already reflected.
2. The next move is as likely to be up as down.
3. The analyst has no systematic advantage.

1. In a semi-strong market, the price does not yet reflect it.
2. She can profit when the bid is announced.
3. This is insider dealing, a criminal offence.

1. Value added per share.
   20 ÷ 10 = ₦2.
2. In a semi-strong market the price moves to about ₦102 on announcement.
3. The share price therefore follows NPV.

How to score full marks

• Define each form by the information reflected.
• Use an example to show when the price moves.
• Link each form to chartism, fundamental analysis and insider dealing.
• State which form is most likely in practice.
• Give the implications for companies and investors.
• Mention behavioural finance as a challenge.

Common mistakes in the exam

• Mixing up the information sets of the forms.
• Saying the semi-strong form rules out insider profits.
• Claiming that efficient prices never change.
• Giving no evidence.
• Forgetting implications for the company.
• Treating behavioural finance as proof the market is always wrong.

Quick revision

• Weak: past prices; random walk; charts fail.
• Semi-strong: public information; fundamental analysis fails; insiders gain.
• Strong: all information; no insider gain.
• Most markets weak; some developed markets semi-strong.
• Implications: no timing, no window-dressing, no bargains, NPV moves price.
• Behavioural finance: bias and extrapolation.
• CAMA 2020: ss. 305, 308, 377(1), 378, 385.

Practice questions

These are original questions written in the style of the Institute of Chartered Accountants of Nigeria (ICAN) exam. Try each one before you open the answer. Full model answers follow the written questions.

Recall check: multiple choice

Recent ICAN papers are written, although older papers such as May 2014 included multiple-choice questions. These questions are for quick recall. The written questions that follow are closer to the exam.

Written questions

Model answers

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