The Perfect Dream Of Stock Investor
Many people suggest that EMT developed in a peculiar manner in scientific research. The proof of the hypothesis came first, beginning with Bachelier in 1900 and proceeding through the wealth of studies reporting randomness in the early 1960s.
Only then was a theory proposed to explain the randomness, beginning with the first explication of EMT in 1965 by Paul Sa- muelson, a recipient of the Nobel Prize in economics in 1970. 6 Economists welcomed this proof. The conditions necessary to produce it seemed tantalizingly close to those necessary to sustain every economist's dream: a perfect market.
The perfect market is a heuristic invented by making the following assumptions concerning a market: There are a large number of participants such that the actions of any individual participant cannot materially affect the market; participants are fully informed, have equal access to the market, and act rationally; the commodity is homogeneous; and there are no transaction costs.
A perfect market would give you exactly what the random walk model was implying: Prices of shares in stock markets should adjust instantaneously and accurately to new information concerning them. That prediction was embodied in EMT as it was first propounded. In its broadest terms, EMT said that the prices of shares traded in stock markets fully reflect all information concerning those shares. Stock markets may or may not have the characteristics assumed by the perfect market model. As the 1976 Nobel laureate Milton Friedman reminds us, however, the cardinal rule of economic forecasting is that a model's predictive power is the only relevant test of its validity, not the assumptions underlying it. 7 Thus, the fact that stock investors are not rational or fully informed, for example, does not matter as long as these realities do not interfere with the predictive power of EMT. While many economists are reconsidering assumptions like these, for now this approach holds sway over accepted economic theory.
