According to Wikipedia:

The efficient-market hypothesis (EMH) is a theory in financial economics that states that asset prices fully reflect all available information. A direct implication is that it is impossible to "beat the market" consistently on a risk-adjusted basis since market prices should only react to new information.

On it's own, this definition makes sense and is intuitive. However, I've heard in a couple of informal discussion that the EMH amounts to saying that you can't forecast the market, or that the best model for forecasting the market is a random walk.

I'm having trouble connecting the second statement with the 1st definition: The whole point of univariate time series forecasting is that we don't need to use causal drivers to forecast a time series, so that even if we don't have any new information, we could still model the time series itself to obtain a reasonable forecast. If we look for example at Amazon stock over the last 5 years (see below), an exponential smoothing model with trend fitted on data from 2015~2017 would have done a pretty good job of forecasting the stock price up until mid 2018. How does this tie into the idea that nobody can beat the market?

Am I misunderstanding the EMH? Or is Amazon stock (and similar tech stocks) part of some sort of fluke/tech bubble that represents an outlier statistically speaking?

enter image description here

  • $\begingroup$ Could you state more precisely your claim about the expected return of Amazon stock conditional on prior information? For a security $i$, you're claiming that fitting an exponential smoother to 3 years of prior securities data generates a good forecast of expected returns going forward? Are you implicitly proposing a momentum strategy, that is, form a portfolio of the highest returning stocks over the past 3 years (because they'll have the strongest trend according to your exponential smoother)? $\endgroup$ – Matthew Gunn Feb 28 '19 at 22:27
  • $\begingroup$ The EMH also does not say that all securities have the same expected return or that returns are not forecastable. I can forecast the return of a U.S. government body with near certainty and that does not violate the EMH. We believe that equities have higher expected returns than U.S. government bonds, and that does not violate the EMH. This answer of mine might be helpful. $\endgroup$ – Matthew Gunn Feb 28 '19 at 22:31

Your Answer

By clicking “Post Your Answer”, you agree to our terms of service, privacy policy and cookie policy

Browse other questions tagged or ask your own question.