The Efficient Market Hypothesis, or EMH, is a financial theory that says the asset (or security) prices reflect all the available information or data. Further, EMP (also called Efficient Market Theory) says it is impossible to beat the market or consistently produce more than average returns.
History and Assumptions
The theory is credited to economist Eugene Fama, who in the 1960s developed it from a Ph.D. dissertation. Fama’s research can be found in his 1970 book, titled – Efficient Capital Markets: A Review of Theory and Empirical Work.
EMH assumes that investors act rationally or normally. For instance, if there is unusual information, then an unusual reaction to it is normal behavior. Or, running in the same direction where everyone else is running is also normal behavior.
Another assumption of the theory is that all relevant information is available freely and widely. Also, such information is shared among all the investors.
Efficient Market Hypothesis – What it Says?
The theory states that at any given point in time, a stock price reflects all available information that is publicly available. Or, we can say the theory says that a stock trades at fair value all the time. Basically, the theory implies that beating the market return is more of a chance than selecting the right stocks by doing research.
Moreover, the EMH also suggests that it is impossible for an investor to find undervalued stocks or sell stocks at a premium. The theory also suggests that fundamental or technical analyses are not useful under the Efficient Market Hypothesis.
A point to note here is that the EMH theory does not say that no investors can beat the market. In fact, it suggests that a few can beat the market return, and a few will perform below the market average. But, the majority will be close to the market average. However, as per the theory, those who beat the market returns are lucky or do so by chance, while those who generate below-market returns are unlucky.
Efficient Market Hypothesis Criticism
Though many support the theory, a few exceptions to the theory exist. The biggest exception is legendary investor Warren Buffett, who has always beaten the market returns in the long term. Others who consistently generate above-market returns are Paul Tudor Jones, John Templeton, and Peter Lynch.
EMH theory refers to those generating above-average market returns as lucky. But, it does not explain how the same people can be lucky all the time, including in the long run.
Also, those against EMH say that a few financial events could push the stock away from its fair value in a single day. For instance, the stock market crash of 1987 pushed DJIA (the Dow Jones Industrial Average) down by over 20% in a day.
We can say that if the assumptions of EMH are correct, then there shouldn’t be any market crash. During a crash, stocks trading at high valuations gets crushed. However, EMH assumes that all securities trade at fair value all the time.
Read factors affecting efficiency in the financial market for more.
Forms of Efficient Market Hypothesis
There are three forms of EMH:
Weak Form EMH
It assumes that the stock price includes all information publicly available and not the information that is not yet publicly available. Also, it assumes the past price, volume, and returns information is unrelated to future prices. This means that technical analysis can’t help an investor to earn above-market returns consistently as past prices can’t predict future prices.
Though the weak-form EMH does give no importance to technical analysis, it does leave open the possibility that high-level fundamental research could help an investor beat an average market return.
This form gives no importance to both technical and fundamental analysis. Semi-strong EMH believes that price adjusts quickly to any new public information. And this leaves no chance for fundamental analysis to predict the price movement. For example, stock prices quickly adjust to inflation data.
Strong Form EMH
This form assumes that both public and private information is priced into the stock price. Private information is usually available to the insiders, such as the CEO of a company. But, Strong Form EMH believes even such information is factored into the stock price.
What Passive and Actives Investors Do?
Those who believe in the EMH or the passive investors can go for the index funds or certain ETFs. Such financial options are managed passively, which means their objective is not to beat the overall market returns. Such an investment strategy also aligns with a common saying “if you can’t beat them, join them.”
On the other hand, active investors can go for technical analysis to predict the price movement. Also, they can go for fundamental analysis to dig out undervalued stocks.
There have been several studies that support the EMH, such as a long-term study by Morningstar. Such studies and the proponents of EMH have led to the rise in the popularity of the funds that try to mirror major indexes.
Also, a point worth noting is that the Efficient Market Hypothesis raises a question about the existence and the business model of the investment companies. Such companies pay a massive amount to fund managers to generate returns more than the average market return.