Castles in the Air:
The Efficient Market Hypothesis
THE THEORY OF the rational market arose as an attempt to provide a scientific underpinning to the Efficient Market Hypothesis, which serves as the cornerstone of financial economics. According to the hypothesis, asset “prices always ‘fully reflect’ available information” (Fama, 1970, p. 383).
As it stands, the Efficient Market Hypothesis says very little about how prices unfold over time, or whether markets allocate capital well. There is an abundance of publicly available information about economic, political, and social factors and events that is quickly disseminated to individuals around the world. Participants select from this flow of information when forming their forecasts of future prices and risk. These forecasts underpin their decisions to buy and sell, which the market aggregates in setting prices. In this way, prices fully reflect the information that participants deem relevant in forecasting.
If by “available information,” one means the particular information chosen by participants in thinking about the future, then the Efficient Market Hypothesis is merely a descriptive hypothesis about markets. To turn it into a theory of asset prices, economists have had to take a stand on what is meant by “all available information” and how it gets “fully reflected in asset prices.”
By presuming that the Rational Expectations Hypothesis adequately captures how intelligent, rational participants forecast future prices and the prospects of assets, the Efficient Market Hy-