A Literature Review of the Efficient Market Hypothesis

The efficient market hypothesis and behavioural finance theory have been the cornerstone of modern asset pricing for the past 50 odd years. Although both theories are fundamental in explaining modern asset pricing, they are opposing views. The efficient market hypothesis dictates that the price of any asset depends on the information, while the behavioural finance theory dictates that the price depends on the reaction of the market participants to the information. Therein lays the key to the argument influencing modern asset pricing, does price immediately reflect the information or market participants’ perception of the information. In this paper, we will critical evaluate the theory influencing the efficient market hypothesis. We will review the neoclassical economics underpinning the efficient market hypothesis and the recent empirical evidence. In concluding, we find that although the efficient market hypothesis has difficulties in testing and the empirical evidence is mixed. Yet it is useful as a benchmark for regulators and central bankers alike. However, market participants are homo sapiens and not homo economics; hence there is a requirement to understand their reaction. So in essence leading to a requirement to include the behavioural finance theory, if we are to understand asset pricing.