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The Efficient Market Hypothesis (EMH) is a beacon in the fog of financial theory. Its core claim - that asset prices fully reflect all available information - is both profound and controversial[1]. The EMH paints a picture of a market where information is free, investors are rational, and mispricings are fleeting. It's a world where the collective wisdom of market participants is distilled into prices with ruthless efficiency.
Yet the reality of markets often seems to mock the pristine assumptions of the EMH. Information is not free, but jealously guarded. Investors are not always rational, but prone to manias and panics. Transactions are not frictionless, but encumbered by costs and barriers. And mispricings can persist for puzzlingly long periods[2]. The EMH, for all its elegance, often seems at odds with the messy reality of markets.
The EMH comes in three flavors: weak, semi-strong, and strong[1][3]. The weak form suggests that current prices reflect all past publicly available information. The semi-strong form assumes that prices instantly change to reflect new public information. The strong form additionally claims that prices instantly reflect even hidden "insider" information[1].
Critics argue that the strong and semi-strong forms do not hold up to empirical scrutiny. Anomalies like the January effect, where stock prices tend to rise in that month, seem to contradict the notion of perfect efficiency[1]. Behavioral economists highlight cognitive biases that lead to irrational investment decision-making[2]. The very existence of market bubbles and crashes seems to defy the EMH.
Enter prediction markets. These novel platforms, which allow trading on the outcomes of future events, have emerged as a fascinating testing ground for the EMH[4]. By aggregating the beliefs of diverse participants, prediction markets aim to arrive at the most accurate forecast - the "wisdom of the crowd" incarnate. In theory, prediction markets should be ruthlessly efficient, rapidly incorporating all relevant information into prices.
But even prediction markets have their limits. In this beautiful piece, TheZvi lists out Five Main Components to a Thriving Prediction Market: