Resolving the Apparent Efficient Market Hypothesis Paradox

Summary

The document poses a conceptual question about the efficient market hypothesis (EMH): if prices reflect available information and investors are rational, why should prices change or investors expect returns? It considers three possibilities: no new price-relevant information, unpredictable future information, or information believed to favor one direction. The questioner suggests each case seems to imply unchanged prices or a predictable return pattern that conflicts with EMH.

This is a framing of the paradox rather than a resolution. It highlights the need to distinguish information already incorporated in current prices from future information that has not yet arrived, and to distinguish expected price changes from compensation for bearing risk. The document provides no answer, evidence, or formal treatment of risk premia, so it does not establish that EMH implies zero expected returns or that rational investors have no reason to invest. Its value is in identifying assumptions that a fuller discussion would need to examine.

Key ideas

• The question examines whether efficient pricing implies zero expected returns.
• It separates cases with no new information, uncertain information, and directional expectations.
• The paradox depends on assumptions about what information is already reflected in prices.
• Expected returns and realized price changes are not resolved in the document.
• The discussion poses a conceptual problem but offers no answer or empirical evidence.

Tags

# Efficient Market Hypothesis paradox?


# Efficient Market Hypothesis paradox?












Here's an apparent paradox that puzzles me. EMH states that asset prices reflect all information available. Investors are assumed to be rational. We can note:

$E(p_{t+1}|\Phi_{t}) = (1+E(r_{t+1}|\Phi_{t}))*p_{t}$

Where E is the expected value operator. $p_{t}$ the price at time t, $r_{t+1}$ the expected one-period return, $\Phi_{t}$ is a general symbol for whatever set of information is assumed to be "fully reflected" in the price at t.

My question is what happens at time $t+1$ and after. I see 3 cases:

Case 1: no new piece of information susceptible to move the price is released. In that case you would expect the price to remain unchanged since all information is already priced in and there is no incentive for a rational economic agent to invest.

Case 2: a new piece of information is released at some point in the future. If you don't what to make any assumption on that future piece of information, you have to assume that pieces of information that drive the price up are as probable as pieces of information that drive the price down. In that case the expected return is 0 by construction and price should remain unchanged. So again no incentive for the agent to invest.

Case 3: you assume the piece of information is likely to drive the price in one particular direction, either up or down. By doing so you also assume a pattern in the future returns which is contrary to what the EMH states.

How can one resolve that apparent paradox?

Shown in full with attribution under the source's licence. Licence: CC BY-SA 4.0 (Stack Exchange)

This summary was written by Stratmill's research agent from the original; it is not a copy of the source.