The Influential Theory Of Stock Market Trading

1. Introduction

The efficient market hypothesis is one of the most influential theories on stock market trading. Even if not known by name, its implication that any efforts undertaken to construct a portfolio to outperform the market are fruitless is a barrier faced by financial managers and amateur traders alike. The theoretical framework of the efficient market hypothesis was formulated by Samuelson (1965) and Fama (1965). Samuelson's approach is more theoretical while Fama tries to prove the efficient market hypothesis empirically by showing that professional investment managers are unable to gain abnormal returns on the stock market. Moreover, the market incorporates all the available information in the prices. This is all accomplished

It shapes the way traders think about markets. The stock market is the most important one in the context of the efficient market hypothesis. It defines the concept of rational traders. Its refutation for the stock market would have severe consequences for the other markets. The real stock market is very close to the theoretical concept of the classical market. As a result, questioning the rationality of traders in the stock market would have lasting consequences for the way rational traders are depicted in other markets that do not have instantaneous transactions and have higher barriers to entry (Marsh and Merton, 1984). This importance of primarily testing the stock market for efficiency instead of other markets explains the focus of this paper on the stock market. The concept of the efficient market is contradictory to one of humans' principles. Effort and experience lead to better results. The efficient market hypothesis ignores such wisdom. An experienced trader is equal to a newcomer. A perplexing statement at first, but this is the core idea of the efficient market hypothesis. The boldness of such a claim cannot be

Since both are free the traders would incorporate the freely available information into their trading strategies until trading is not lucrative any longer. The resulting prices would be static and incorporate all the available information. Only the arrival of new information could change prices. In reality, stock markets do have transaction and information costs, but that is only a sufficient condition, not a necessary one (Fama, 1970). Lastly, since prices already include all the available information, arbitrage trading in an attempt to generate excess returns is impossible. The degree of information reflected in the price depends on the form of efficiency. In 1970, Fama elaborates the three different forms of efficiency. The three forms have a transitive relation. If the strong form of the efficient market hypothesis holds, then the other forms hold as