What is the Efficient Markets Hypothesis?

What is the Efficient Markets Hypothesis?

The efficient market hypothesis (EMH), alternatively known as the efficient market theory, is a hypothesis that states that share prices reflect all information and consistent alpha generation is impossible.

According to the EMH, stocks always trade at their fair value on exchanges, making it impossible for investors to purchase undervalued stocks or sell stocks for inflated prices.

Therefore, it should be impossible to outperform the overall market through expert stock selection or market timing, and the only way an investor can obtain higher returns is by purchasing riskier investments.

Three Variations Of the Efficient Market Hypothesis

Investors who strongly believe in the efficient market hypothesis choose passive investment strategies that mirror benchmark performance, but they may do so to varying degrees. There are three main variations on the theory:

1. The Weak Form of the Efficient Market Hypothesis

Although investors abiding by the efficient market hypothesis believe that security prices reflect all available public market information, those following the weak form of the hypothesis assume that prices might not reflect new information that hasn’t yet been made available to the public.

It also assumes that past prices do not influence future prices, which will instead be informed by new information. If this is the case, then technical analysis is a fruitless endeavor.

The weak form of the efficient market hypothesis leaves room for a talented fundamental analyst to pick stocks that outperform in the short-term, based on their ability to predict what new information might influence prices.

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2. The Semi-Strong Form of the Efficient Market Hypothesis

This form takes the same assertions of weak form, and includes the assumption that all new public information is instantly priced into the market. In this way, neither fundamental nor technical analysis can be used to generate excess returns.

3. The Strong Form of the Efficient Market Hypothesis

Strong form efficient market hypothesis followers believe that all information, both public and private, is incorporated into a security’s current price. In this way, not even insider information can give investors an opportunity for excess returns.

Arguments For and Against the Efficient Market Hypothesis

Supporters and opponents of the efficient markets hypothesis can both make a case to support their views. Supporters of the EMH often argue their case based either on the basic logic of the theory or on a number of studies that have been done that seem to support it.

A long-term study by Morningstar found that, over a 10-year span of time, the only types of actively managed funds that were able to outperform index funds even half of the time were U.S. small growth funds and emerging markets funds. Other studies have revealed that less than one in four of even the best-performing active fund managers proves capable of outperforming index funds on a consistent basis.

Note that such data calls into question the whole investment advisory business model that has investment companies paying out huge amounts of money to top fund managers, based on the belief that those money managers will be able to generate returns well above the average overall market return.

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Opponents of the efficient markets hypothesis advance the simple fact that there ARE traders and investors – people such as John Templeton, Peter Lynch, and Paul Tudor Jones – who DO consistently, year in and year out, generate returns on investment that dwarf the performance of the overall market. According to the EMH, that should be impossible other than by blind luck. However, blind luck can’t explain the same people beating the market by a wide margin, over and over again. over a long span of time.

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