characteristics of efficient market hypothesis

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Efficient Markets Hypothesis

The efficient market hypothesis (EMH) suggests that financial markets operate in such a way that the prices of equities, or shares in companies, are always efficient.

Elliot currently works as a Private Equity Associate at Greenridge Investment Partners, a middle market fund based in Austin, TX. He was previously an Analyst in  Piper Jaffray 's Leveraged Finance group, working across all industry verticals on  LBOs , acquisition financings, refinancings, and recapitalizations. Prior to Piper Jaffray, he spent 2 years at  Citi  in the Leveraged Finance Credit Portfolio group focused on origination and ongoing credit monitoring of outstanding loans and was also a member of the Columbia recruiting committee for the Investment Banking Division for incoming summer and full-time analysts.

Elliot has a Bachelor of Arts in Business Management from Columbia University.

• What Is The Efficient Market Hypothesis (EMH)?
• Variations Of The Efficient Markets Hypothesis
• Are Capital Markets Efficient?

What Is the Efficient Market Hypothesis (EMH)?

The efficient market hypothesis (EMH) suggests that  financial markets operate in such a way that the prices of equities, or shares in companies, are always efficient. In simpler terms, these prices accurately reflect the true value of the underlying companies they represent.

The efficient market hypothesis is one of the most foundational theories developed in finance. It was developed by Nobel laureate Eugene Fama in the 1960s and is widely known amongst finance professionals in the industry.

There are many implications arising from this hypothesis; however, the main proposition is that it is impossible to “beat the market” and generate alpha. 

What does beating the market or generating alpha mean? Broadly speaking, you can think of how much the return of your risk-adjusted investments exceeds benchmark indices. 

For example, a proxy for the US market will be the S&P 500, which covers the top 500 companies in the United States or over 80% of its total market capitalization .

If your portfolio of investments generated an alpha of 3%, then it is considered that your portfolio outperformed the S&P 500 by 3% (assuming that you trade in the US market)

How is it possible that share prices are always efficient and reflect the actual value of the underlying company following the efficient market hypothesis? 

It is because, at all times, a company's share price reflects certain relevant available information to all investors who trade upon it, and the type of information required to ensure efficient prices depends on what form of efficiency the market is in. 

If you are interested in a profession surrounding capital markets, be it asset management , sales & trading, or even hedge funds, the EMH is a theory you need to know to ace your interviews. 

However, this is only one topic in the diverse world of finance that you will truly need to know if you want to break into these careers. To gain a deeper understanding of finance, look at Wall Street Oasis's courses. For a link to our courses, click  here .

Key Takeaways

• Developed by Eugene Fama, the EMH suggests that financial markets reflect all available information and that it's impossible to consistently "beat the market" to generate abnormal returns (alpha).
• The EMH has three forms: weak, semi-strong, and strong. Each form describes the extent of information already reflected in stock prices.
• Under this form, stock prices incorporate historical information like past earnings and price movements. Investors can't gain alpha by trading on this historical data as it's already "priced in."
•  In this form, stock prices reflect all publicly available information, including recent news and announcements. Even with access to this information, investors can't consistently beat the market.
• The strongest form of EMH incorporates all information, including insider information. Even with insider knowledge, investors can't generate abnormal returns. However, some argue that real-world markets may not fully adhere to this hypothesis due to behavioral biases and inefficiencies.

Variations of the Efficient Markets Hypothesis

According to Eugene Fama, there are three variations of efficient markets:

Semi-strong form 

Strong form 

Depending on which form the market takes, the share price of companies incorporates different types of information. Let’s go over what kind of information is required for each form of the efficient market. 

Weak form efficiency

Under the weak form of efficient markets, share prices incorporate all historical information of stocks. This would typically cover a company’s historical earnings, price movements, technical indicators, etc. 

Another way to look at it is that when a market is weakly efficient, it means - there is no predictive power from historical information. 

Investors are unlikely to generate alpha from investing in a company just because they saw that the company outperformed earnings estimates last week. That information was already “priced in,” and there is nothing to gain trading off that information.

Semi-strong form efficiency 

The semi-strong form of efficiency within markets is believed to be most prevalent across markets. Under this form of efficiency, share prices incorporate all historical information of stocks and go a step further by including all publicly available information. 

This implies that share prices practically adjust immediately following the announcement of relevant information to a company’s stock.

What this means is that investors are not able to generate alpha by trading off relevant information that is publicly available, no matter how recent that piece of information became public.

This partially explains why you’ve probably heard those investment gurus tell you to buy the rumors and sell on the news.

One relevant example would be the reaction from every stock exchange worldwide on specific key dates surrounding the World Health Organization and the Covid-19 pandemic. 

The market crashed following specific announcements because, at that time, the market anticipated lockdowns to occur, which would damage every company’s supply chain and sales. 

If lockdowns did occur, companies wouldn’t be able to produce goods and services. Furthermore, customers wouldn’t be able to purchase goods, resulting in companies taking a hit on their earnings. And this was exactly what happened. 

Although Covid was known since November 2019, If you look at the S&P 500 and the FTSE 100 , they both crashed on the same date (21st February 2020), with the impact on markets being equally significant. 

It would be safe to say that this was the date that the market started incorporating the impact of Covid-19 on a company’s share price. It is no coincidence that the World Health Organization also hosted a  press conference  that day. 

You can look at the FTSE 100 and S&P 500 index, which represent the UK and US market conditions. The following images show the drop in benchmark indices due to Covid-19: 

Unfortunately, there are a couple of caveats to this example. 

In Eugene Fama’s  purest  depiction of the semi-strong form of an efficient market hypothesis, prices are meant to adjust instantaneously following the public announcement of relevant information, with the new prices reflecting the market’s new actual value. 

When you look at the market’s reaction to Covid-19, the market crash happened gradually over a certain period. 

Furthermore, if you look at the FTSE 100 and S&P 500, the index started showing signs of recovery immediately after the market crash. 

Broadly speaking, there are two reasons this could have happened: 

There was an announcement of new publicly available information with a positive impact on markets

The market had initially overreacted to the Covid-19 pandemic

An excellent example of newly announced publicly available information with a positive impact on markets would be something like the respective countries’ governments and central banks both promoting aggressive monetary and fiscal policies designed to improve economic situations. 

Although it is impossible to say, and every investor will have a different opinion on the market, the consensus is that the market has reacted to monetary and fiscal policies. As a result, there was an initial overreaction to Covid-19 in the market. 

This is where the practical example strays away from theory. In the market’s reaction to Covid-19, the impact of new information was gradual (but still quick) and argued to be inefficient at the trough. 

However, Eugene Fama’s efficient market hypothesis anticipates rapid price movements following the release of public information, and prices are always efficient, moving from one true value to another. 

Market indices that genuinely follow the semi-strong form efficient market hypothesis would look something like this: 

And this is what the  true  efficient market hypothesis envisions. There is no exaggeration in this graph, and the market index isn't expected to have any daily fluctuation because it reflects the valid, efficient value pricing in all the publicly available information. 

Reaction to new relevant information is instant and accurate, leaving no room for values to readjust over time. 

This example applies to all forms of efficient markets, including the weak and strong forms. However, the difference is the type of information that will cause a company's share price to readjust. 

Strong form efficiency 

The share prices of companies in strongly efficient markets incorporate everything that the semi-strong form efficiency incorporates but go a step further by also incorporating insider information. 

This implies that investors who know something about a company that isn't publicly known cannot generate abnormal returns trading off that information.

Generally speaking, you should expect more developed countries to have more efficient markets, mainly because more asset managers are analyzing stocks and more educated individuals make better investment decisions.

However, if any country were likely to display powerfully efficient markets, you would expect them to exist within more corrupt and opaque countries. This is because countries like the US and UK have implemented sanctions against insider trading purely because of how profitable it is. 

Investors with insider information are known to have an edge in markets, which is why there are policies in place dictating that asset managers and substantial shareholders must disclose their trades to the Securities and Exchange Commission ( SEC ). 

Under  Rule 10b-5 , the SEC explicitly states that insiders are prohibited from trading on material non-public information. 

In November 2021, a  McKinsey partner was charged with insider trading  because he assisted Goldman Sachs with its acquisition of GreenSky. 

The Mckinsey partner had private information regarding the GreenSky acquisition and purchased multiple call options on GreenSky, profiting over $450,000. 

Aside from the fact that the man was blatantly insider trading, the fact that he was able to profit off insider information is evidence that the US market does  NOT  possess strong form efficiency.

The above is somewhat considered to be proof by contradiction. If markets were efficient, trading off insider information would not let investors generate abnormal returns. But in this case, the Mckinsey partner could make almost half a million dollars!

To put that into perspective, $450 thousand is more than two years of the average investment banking analyst’s total compensation and slightly over four years of base pay. 

Are capital markets efficient?

After developing a decent understanding of the efficient market hypothesis, the real question is: is the market truly efficient, and do they follow the EMH? This topic is controversial, and many individuals will support different sides of the argument. 

Supporters of the efficient market hypothesis generally believe in traditional neoclassical finance. Neoclassical finance has been around since the twentieth century, and its approach revolves around key assumptions like perfect knowledge or rationality among individuals. 

In fact, most of the material taught at university and in textbooks are materials that talk about neoclassical finance - one might argue that the world of finance was built by theories such as the EMH. 

However, some of the assumptions in neoclassical finance have always been known to be overly restrictive and not at all realistic. For example, humans are not the objective supercomputers that neoclassical finance believes us to be. 

The fact is that humans are ruled by emotions and subjected to behavioral biases. We do not act the same as everyone else, and it is absurd to believe that we all behave rationally or even have perfect knowledge about a subject before making decisions.

Some of the latest developments in academics have been surrounding behavioral finance, with Nobel laureates including Robert Shiller and Richard Thaler (cameo in a classic finance film titled The Big Short) leading the field and relaxing unrealistic assumptions in neoclassical finance. 

Aside from being unable to generate alpha, another significant implication arising from the EMH is that investors can blindly purchase any stock in the exchange without any prior analysis and still receive a fair return on equity . 

That does not make sense because if everyone did that, then it would be safe to assume that the share prices would be wildly inaccurate and far apart from the company’s actual value. 

The fact is that there is some reliance upon financial institutions such as asset managers or arbitrageurs to constantly monitor and exploit inefficiencies within capital markets (such as buying underpriced and shorting overpriced equities) to keep the market efficient. 

Therefore, another argument arising from this is the idea that markets are efficiently inefficient where money managers who use costly financial information software such as Bloomberg Terminal or FactSet can gain a competitive edge in the market.

These money managers generate abnormal returns by exploiting inefficiencies within markets, such as longing for undervalued stocks or shorting overvalued stocks. A beneficial outcome of this activity is that market prices are slowly shifting towards efficient values.

The biggest argument supporting the efficient market hypothesis is that many money managers cannot outperform benchmark indices such as the S&P 500 on a year-to-year basis.

That argument is further supported when you compare the average 20-year annual return of the S&P 500 to any hedge fund’s average 20-year yearly return. You will find that  MOST  money managers underperform compared to the benchmark. 

The table below displays the November 2021 return of the top hedge funds. For reference, the S&P 500 had a total return of  26.89% . 

Therefore, if you compare the hedge funds to the S&P 500 (ignoring the hedge funds’ December 2021 performance), you can see that only three hedge funds outperformed the index. 

Hedge funds are also costly, with many institutions imposing a minimum 2-20 fee structure where there is a 2% fee charged on the AUM of the fund and a 20% fee for any profit above the hurdle rate. 

Nevertheless, while the data seems to point to the fact that hedge funds can be somewhat lackluster, a common argument is that the concept of a hedge fund is to “hedge,” which means to protect money. 

Therefore, perhaps some hedge funds have a greater purpose of maintaining their AUM rather than growing it despite the fact that hedge funds are known for having the most aggressive investment strategies . 

Overall, being a part of a hedge fund is still highly lucrative. For example, Kenneth Griffin, CEO of Citadel LLC, had total compensation of over $2 billion in 2021, whereas David Solomon, CEO of Goldman Sachs, had a total payment of $35 million in 2021. 

If you want to make $2 billion a year in a hedge fund one day, you need to polish up your interviewing skills. To impress your interviewers, look at Wall Street Oasis’s Hedge Fund Interview Prep Course. For a link to our courses, click  here .

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What is Efficient Market Hypothesis? | EMH Theory Explained

The efficient market hypothesis (EMH) can help explain why many investors opt for passive investing strategies, such as buying index funds or exchange-traded funds ( ETFs ), which generate consistent returns over an extended period. However, the EMH theory remains controversial and has found as many opponents as proponents. This guide will explain the efficient market hypothesis, how it works, and why it is so contradictory. 

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What is the efficient market hypothesis?

The efficient market hypothesis (EMH) claims that all assets are always fairly and accurately priced and trade at their fair market value on exchanges. If this theory is true, nothing can give you an edge to outperform the market using different investing strategies and make excess profits compared to those who follow market indexes.

Efficient market definition

An efficient market is where all asset prices listed on exchanges fully reflect their true and only value, thus making it impossible for investors to “beat the market” and profit from price discrepancies between the market price and the stock’s intrinsic value. The EMH claims the stock’s fair value, also called intrinsic value , is much the same as its market value , and finding undervalued or overvalued assets is non-viable.  

Intrinsic value refers to an asset’s true, actual value, which is calculated using fundamental and technical analysis, whereas the market price is the currently listed price at which stock is bought and sold. When markets are efficient, the two values should be the same, but when they differ, it poses opportunities for investors to make an excess profit.

For markets to be completely efficient, all information should already be accounted for in stock prices and are trading on exchanges at their fair market value, which is practically impossible.

Hypothesis definition 

A hypothesis is merely an assumption, an idea, or an argument that can be tested and reasoned not to be true. Something that isn’t fully supported by full facts or doesn’t match applied research.

For example, if sugar causes cavities, people who eat a lot of sweets are prone to cavities. And if the same applies here – if all information is reflected in a stock’s price, then its fair value should be the same as its market value and can not differ or be impacted by any other factors. 

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Fundamental and technical analysis in an efficient market 

According to the EMH, stock prices are already accurately priced and consider all possible information. If markets are fully efficient, then no fundamental or technical analysis can help investors find anomalies and make an extra profit. 

Fundamental analysis is a method to calculate a stock’s fair or intrinsic value by looking beyond the current market price by examining additional external factors like financial statements, the overall state of the economy, and competition, which can help define whether the stock is undervalued. 

Also relevant is technical analysis , a method of forecasting the value of stocks by analyzing the historical price data, mainly looking at price and volume fluctuations occurring daily, weekly, or any other constant period, usually displayed on a chart.

The efficient market theory directly contradicts the possibility of outperforming the market using these two strategies; however, there are three different versions of EMH, and each slightly differs from the other.

Three forms of market efficiency 

The efficient market hypothesis can take three different forms , depending on how efficient the markets are and which information is considered in theory: 

1. Strong form efficiency  

Strong form efficiency is the EMH’s purest form, and it is an assumption that all current and historical, both public and private, information that could affect the asset’s price is already considered in a stock’s price and reflects its actual value. According to this theory, stock prices listed on exchanges are entirely accurate. 

Investors who support this theory trust that even inside information can’t give a trader an advantage, meaning that no matter how much extra information they have access to or how much analysis and research they do, they can not exceed standard returns. 

Burton G. Malkiel, a leading proponent of the strong-form market efficiency hypothesis, doesn’t believe any analysis can help identify price discrepancies. Instead, he firmly believes in buy-and-hold investing, trusting it is the best way to maximize profits. However, factual research doesn’t support the possibility of a strong form of efficiency in any market. 

2. Semi-strong form efficiency

The semi-strong version of the EMH suggests that only current and historical public (and not private) information is considered in the stock’s listed share prices. It is the most appropriate form of the efficient market hypothesis, and factual evidence supports that most capital markets in developed countries are generally semi-strong efficient. 

This form of efficiency relies on the fact that public news about a particular stock or security has an immediate effect on the stock prices in the market and also suggests that technical and fundamental analysis can’t be used to make excess profits.   

A semi-strong form of market efficiency theory accepts that investors can gain an advantage in trading only when they have access to any unknown private information unknown to the rest of the market.

3. Weak form efficiency

Weak market efficiency, also called a random walk theory, implies that investors can’t predict prices by analyzing past events, they are entirely random, and technical analysis cannot be used to beat the market. 

Random walk theory proclaims stock prices always take a randomized path and are unpredictable, that investors can’t use past price changes and historical data trends to predict future prices, and that stock prices already reflect all current information. 

For example, advocates of this form see no or limited benefit to technical analysis to discover investment opportunities. Instead, they would maintain a passive investment portfolio by buying index funds that track the overall market performance. 

For example, the momentum investing method analyzes past price movements of stocks to predict future prices – it goes directly against the weak form efficiency, where all the current and past information is already reflected in their market prices.  

A brief history of the efficient market hypothesis

The concept of the efficient market hypothesis is based on a Ph.D. dissertation by Eugene Fama , an American economist, and it assumes all prices of stocks or other financial instruments in the market are entirely accurate. 

In 1970, Fama published this theory in “Efficient Capital Markets: A Review of Theory and Empirical Work,” which outlines his vision where he describes the efficient market as: “A market in which prices always “fully reflect” available information is called “efficient.”

Another theory based on the EMH, the random walk theory by Burton G. Malkiel , states that prices are completely random and not dependent on any factor. Not even past information, and that outperforming the market is a matter of chance and luck and not a point of skill.

Fama has acknowledged that the term can be misleading and that markets can’t be efficient 100% of the time, as there is no accurate way of measuring it. The EMH accepts that random and unexpected events can affect prices but claims they will always be leveled out and revert to their fair market value.

What is an inefficient market? 

The efficient market hypothesis is a theory, and in reality, most markets always display some inefficiencies to a certain extent. It means that market prices don’t always reflect their true value and sometimes fail to incorporate all available information to be priced accurately. 

In extreme cases, an inefficient market may even lead to a market failure and can occur for several reasons.

An inefficient market can happen due to: 

• A lack of buyers and sellers; 
• Absence of information; 
• Delayed price reaction to the news;
• Transaction costs;
• Human emotion;
• Market psychology.

The EMH claims that in an efficiently operating market, all asset prices are always correct and consider all information; however, in an inefficient market, all available information isn’t reflected in the price, making bargain opportunities possible.

Moreover, the fact that there are inefficient markets in the world directly contradicts the efficient market theory, proving that some assets can be overvalued or undervalued, creating investment opportunities for excess gains. 

Validity of the efficient market hypothesis 

With several arguments and real-life proof that assets can become under- or overvalued, the efficient market hypothesis has some inconsistencies, and its validity has repeatedly been questioned. 

While supporters argue that searching for undervalued stock opportunities using technical and fundamental analysis to predict trends is pointless, opponents have proven otherwise. Although academics have proof supporting the EMH, there’s also evidence that overturns it. 

The EMH implies there are no chances for investors to beat the market, but for example, investing strategies like arbitrage trading or value investing rely on minor discrepancies between the listed prices and the actual value of the assets. 

A prime example is Warren Buffet, one of the world’s wealthiest and most successful investors, who has consistently beaten the market over more extended periods through value investing approach, which by definition of EMH is unfeasible. 

Another example is the stock market crash in 1987, when the Dow Jones Industrial Average (DJIA) fell over 20% on the same day, which shows that asset prices can significantly deviate from their values. 

Moreover, the fact that active traders and active investing techniques exist also displays some evidence of inconsistencies and that a completely efficient market is, in reality, impossible. 

Contrasting beliefs about the efficient market hypothesis

Although the EMH has been largely accepted as the cornerstone of modern financial theory, it is also controversial. The proponents of the EMH argue that those who outperform the market and generate an excess profit have managed to do so purely out of luck, that there is no skill involved, and that stocks can still, without a real cause or reason, outperform, whereas others underperform. 

Moreover, it is necessary to consider that even new information takes time to take effect in prices, and in actual efficiency, prices should adjust immediately. If the EMH allows for these inefficiencies, it is a question of whether an absolute market efficiency, strong form efficiency, is at all possible. But as this theory implies, there is little room for beating the market, and believers can rely on returns from a passive index investing strategy.

Even though possible, proponents assume neither technical nor fundamental analysis can help predict trends and produce excess profits consistently, and theoretically, only inside information could result in outsized returns. 

Moreover, several anomalies contradict the market efficiency, including the January anomaly, size anomaly, and winners-losers anomaly, but as usual, factual evidence both contradicts and supports these anomalies.  

Parting opinions about the different versions of the EMH reflect in investors’ investing strategies. For example, supporters of the strong form efficiency might opt for passive investing strategies like buying index funds. In contrast, practitioners of the weak form of efficiency might leverage arbitrage trading to generate profits.

Marketing strategies in an efficient and inefficient market 

On the one side, some academics and investors support Fama’s theory and most likely opt for passive investing strategies. On the other, some investors believe assets can become undervalued and try to use skill and analysis to outperform the market via active trading.

Passive investing

Passive investing is a buy-and-hold strategy where investors seek to generate stable gains over a more extended period as fewer complexities are involved, such as less time and tax spent compared to an actively managed portfolio. 

People who believe in the efficient market hypothesis use passive investing techniques to create lower yet stable gains and use strategies with optimal gains through maximizing returns and minimizing risk.

Proponents of the EMH would use passive investing, for example: 

• Invest in Index Funds;
• Invest in Exchange-traded Funds (ETFs).

However, it is important to note that other mutual funds also use active portfolio management intending to outperform indices, and passive investing strategies aren’t only for those who believe in the EMH.

Active investing

Active portfolio managers use research, analysis, skill, and experience to discover market inefficiencies to generate a higher profit over a shorter period and exceed the benchmark returns. 

Generally, passive investing strategies generate returns in the long run, whereas active investing can generate higher returns in the short term. 

Opponents of the EMH might use active investing techniques, for example: 

• Arbitrage and speculation; 
• Momentum investing ;
• Value investing .

The fact that these active trading strategies exist and have proven to generate above-market returns shows that prices don’t always reflect their market value. 

For instance, if a technology company launches a new innovative product, it might not be immediately reflected in its stock price and have a delayed reaction in the market. 

Suppose a trader has access to unpublished and private inside information. In that case, it will allow them to purchase stocks at a much lower value and sell for a profit after the announcement goes public, capitalizing on the speculated price movements. 

Passive and active portfolio managers are often compared in terms of performance, e.g., investment returns, and research hasn’t fully concluded which one outperforms the other, 

Efficient market examples

Investors and academics have divided opinions about the efficient market hypothesis, and there have been cases where this theory has been overturned and proven inaccurate, especially with strong form efficiency. However, proof from the real world has shown how financial information directly affects the prices of assets and securities, making the market more efficient. 

For example, when the Sarbanes-Oxley Act in the United States, which required more financial transparency through quarterly reporting from publicly traded businesses, came into effect in 2002, it affected stock price volatility. Every time a company released its quarterly numbers, stock market prices were deemed more credible, reliable, and accurate, making markets more efficient. 

Example of a semi-strong form efficient market hypothesis

Let’s assume that ‘stock X’ is trading at $40 per share and is about to release its quarterly financial results. In addition, there was some unofficial and unconfirmed information that the company has achieved impressive growth, which increased the stock price to $50 per share. 

After the release of the actual results, the stock price decreased to $30 per share instead. So whereas the general talk before the official announcement made the stock price jump, the official news launch dropped it. 

Only investors who had inside private information would have known to short-sell the stock , and the ones who followed the publicly available information would have bought it at a high price and incurred a loss. 

What can make markets more efficient?

There are a few ways markets can become more efficient, and even though it is easy to prove the EMH has no solid base, there is some evidence its relevance is growing. 

First , markets become more efficient when more people participate, buy and sell and engage, and bring more information to be incorporated into the stock prices. Moreover, as markets become more liquid, it brings arbitrage opportunities; arbitrageurs exploiting these inefficiencies will, in turn, contribute to a more efficient market.

Secondly , given the faster speed and availability of information and its quality, markets can become more efficient, thus reducing above-market return opportunities. A thoroughly efficient market, strong efficiency, is characterized by the complete and instant transmission of information. 

To make this possible, there should be: 

• Complete absence of human emotion in investing decisions;
• Universal access to high-speed pricing analysis systems; 
• Universally accepted system for pricing stocks;
• All investors accept identical returns and losses. 

The bottom line

At its core, market efficiency is the ability to incorporate all information in stock prices and provide the most accurate opportunities for investors; however, it isn’t easy to imagine a fully efficient market. 

Research has shown that most developed capital markets fall into the semi-strong efficient category. However, whether or not stock markets can be fully efficient conclusively and to what degree continues to be a heated debate among academics and investors.

Disclaimer:  The content on this site should not be considered investment advice. Investing is speculative. When investing, your capital is at risk.

FAQs on the efficient market hypothesis

The efficient market hypothesis (EMH) claims that prices of assets such as stocks are trading at accurate market prices, leaving no opportunities to generate outsized returns. As a result, nothing could give investors an edge to outperform the market, and assets can’t become under- or overvalued.

What are three forms of the efficient market hypothesis?

The efficient market hypothesis takes three forms: first, the purest form is strong form efficiency, which considers current and past information. The second form is semi-strong efficiency, which includes only current and past public, and not private, information. Finally, the third version is weak form efficiency, which claims stock prices always take a randomized path.

What contradicts the efficient market hypothesis?

The efficient market hypothesis directly contradicts the existence of investment strategies, and cases that have proved to generate excess gains are possible, for example, via approaches like value or momentum investing.

When more investors engage in the market by buying and selling, they also bring more information that can be incorporated into the stock prices and make them more accurate. Moreover, the faster movement of information and news nowadays increases accuracy and data quality, thus making markets more efficient. 

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11.5 Efficient Markets

Learning outcomes.

By the end of this section, you will be able to:

• Understand what is meant by the term efficient markets .
• Understand the term operational efficiency when referring to markets.
• Understand the term informational efficiency when referring to markets.
• Distinguish between strong, semi-strong, and weak levels of efficiency in markets.

Efficient Markets

For the public, the real concern when buying and selling of stock through the stock market is the question, “How do I know if I’m getting the best available price for my transaction?” We might ask an even broader question: Do these markets provide the best prices and the quickest possible execution of a trade? In other words, we want to know whether markets are efficient. By efficient markets , we mean markets in which costs are minimal and prices are current and fair to all traders. To answer our questions, we will look at two forms of efficiency: operational efficiency and informational efficiency.

Operational Efficiency

Operational efficiency concerns the speed and accuracy of processing a buy or sell order at the best available price. Through the years, the competitive nature of the market has promoted operational efficiency.

In the past, the NYSE (New York Stock Exchange) used a designated-order turnaround computer system known as SuperDOT to manage orders. SuperDOT was designed to match buyers and sellers and execute trades with confirmation to both parties in a matter of seconds, giving both buyers and sellers the best available prices. SuperDOT was replaced by a system known as the Super Display Book (SDBK) in 2009 and subsequently replaced by the Universal Trading Platform in 2012.

NASDAQ used a process referred to as the small-order execution system (SOES) to process orders. The practice for registered dealers had been for SOES to publicly display all limit orders (orders awaiting execution at specified price), the best dealer quotes, and the best customer limit order sizes. The SOES system has now been largely phased out with the emergence of all-electronic trading that increased transaction speed at ever higher trading volumes.

Public access to the best available prices promotes operational efficiency. This speed in matching buyers and sellers at the best available price is strong evidence that the stock markets are operationally efficient.

Informational Efficiency

A second measure of efficiency is informational efficiency, or how quickly a source reflects comprehensive information in the available trading prices. A price is efficient if the market has used all available information to set it, which implies that stocks always trade at their fair value (see Figure 11.12 ). If an investor does not receive the most current information, the prices are “stale”; therefore, they are at a trading disadvantage.

Forms of Market Efficiency

Financial economists have devised three forms of market efficiency from an information perspective: weak form, semi-strong form, and strong form. These three forms constitute the efficient market hypothesis. Believers in these three forms of efficient markets maintain, in varying degrees, that it is pointless to search for undervalued stocks, sell stocks at inflated prices, or predict market trends.

In weak form efficient markets, current prices reflect the stock’s price history and trading volume. It is useless to chart historical stock prices to predict future stock prices such that you can identify mispriced stocks and routinely outperform the market. In other words, technical analysis cannot beat the market. The market itself is the best technical analyst out there.

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The Efficient Market Hypothesis

Matthias Hossp 3/19/2024

As an expert in the field, I am thrilled to present to you this comprehensive guide on the Efficient Market Hypothesis (EMH). In this article, we will explore the key concepts, the three forms of market efficiency, the underlying assumptions, and the criticisms surrounding this theory.

Understanding the Efficient Market Hypothesis

Before diving into the details, let’s start by understanding what the Efficient Market Hypothesis is all about. In simple terms, the EMH suggests that financial markets are efficient in processing and incorporating all available information into asset prices. In other words, it implies that it is impossible to consistently achieve above-average returns by outsmarting the market.

One of the key implications of the Efficient Market Hypothesis is that it poses a challenge to active investment strategies that aim to beat the market through stock picking or market timing. According to the EMH, such strategies are unlikely to consistently outperform the market in the long run, as all available information is already reflected in asset prices.

The Concept of Efficient Market Hypothesis

The concept of the EMH originated from the idea that market prices reflect rational investor behavior and that any deviations from market efficiency are temporary and unpredictable. Proponents argue that it is a direct result of the competition among market participants to use available information to their advantage.

Furthermore, the Efficient Market Hypothesis is often categorized into three forms: weak, semi-strong, and strong. The weak form suggests that all past price information is already reflected in current prices, making it impossible to gain an edge through technical analysis . The semi-strong form extends this idea to all publicly available information, including financial statements and economic data. Lastly, the strong form posits that even insider information cannot be used to consistently outperform the market, as it is quickly incorporated into prices.

The Origins of the Efficient Market Hypothesis

The roots of the EMH can be traced back to the works of Eugene Fama in the 1960s and 1970s. Fama, a renowned economist, developed the theory by studying the behavior of stock market prices and challenging the prevailing notion that markets are predictable.

Fama’s research laid the foundation for modern finance theory and revolutionized the way investors perceive the markets. By demonstrating that stock prices follow a random walk and are not predictable based on past information, Fama’s work highlighted the efficiency of financial markets in processing and reflecting all available information.

The Three Forms of Market Efficiency

Within the framework of the Efficient Market Hypothesis (EMH), market efficiency is classified into three forms, each representing a different level of information incorporation into asset prices.

Weak Form Efficiency

In weak form efficiency, asset prices already reflect all historical price and trading data. This implies that past stock prices and trading volumes are not useful in predicting future price movements. Consequently, technical analysis based on historical data is considered ineffective in identifying profitable trading opportunities.

One of the key implications of weak form efficiency is that investors cannot consistently outperform the market by solely relying on historical price data or patterns. This challenges the idea of market timing strategies based on historical trends and emphasizes the importance of other forms of analysis in making investment decisions.

Semi-Strong Form Efficiency

Semi-strong form efficiency goes a step further by asserting that asset prices reflect not only historical information but also all publicly available information. This encompasses financial statements, economic data, news releases, and other widely disseminated information. As a result, fundamental analysis , which involves analyzing financial data, is unlikely to consistently generate superior returns.

Investors operating in a semi-strong efficient market must focus on acquiring non-public information or developing unique insights to gain a competitive edge. This form of efficiency challenges investors to look beyond publicly available data and seek alternative sources of information to make informed investment decisions.

Strong Form Efficiency

Strong form efficiency represents the most extreme version of the EMH, asserting that asset prices reflect all information, both public and private. In other words, no individual or group can consistently profit by leveraging non-public information. This challenges the notion of insider trading, suggesting that it is impossible to make substantial gains consistently based on non-public information.

For market participants, the concept of strong form efficiency underscores the importance of ethical behavior and transparency in financial markets. It promotes fair and equal access to information for all investors, leveling the playing field and reducing the potential for market manipulation based on undisclosed information.

The Assumptions of the Efficient Market Hypothesis

To understand the implications of the Efficient Market Hypothesis (EMH), it is essential to delve deeper into the underlying assumptions that form the bedrock of this widely debated theory.

One of the key assumptions of the EMH is the rationality of investors. The hypothesis posits that market participants are rational beings who process information efficiently, evaluate risks and rewards accurately, and ultimately make logical investment decisions. While this assumption is fundamental to the theory, critics argue that in reality, human behavior can often be influenced by emotions and cognitive biases, leading to irrational decision-making and potentially creating market inefficiencies.

Rationality of Investors

The EMH assumes that investors are rational, meaning they process information efficiently, weigh risks and rewards accurately, and make logical investment decisions. However, it is worth noting that in practice, individuals may exhibit irrational behavior, leading to market inefficiencies.

Another crucial assumption of the EMH is the independent distribution of price changes. This assumption suggests that each price movement in the market is unrelated to previous movements, implying that past price changes do not impact future price movements. This assumption is particularly significant in the context of the weak form of market efficiency, where technical analysis, which relies on historical price data, is considered ineffective in predicting future price movements.

Independent Distribution of Price Changes

Another assumption of the EMH is that price changes are independent of each other, which means that past price movements do not influence future price movements. This assumption is crucial for the weak form of efficiency, where technical analysis is deemed ineffective.

Lastly, the EMH assumes that information is efficiently and swiftly reflected in asset prices. This assumption implies that all relevant information is rapidly incorporated into market prices, leaving no room for undervalued or overvalued assets to persist for an extended period. In an ideal efficient market, investors have access to all available information and act on it promptly, ensuring that prices adjust instantaneously to new information.

The Impact of Information on Prices

Finally, the EMH assumes that information swiftly and accurately flows into the market, and asset prices adjust promptly in response. Essentially, this implies that no valuable information is overlooked or mispriced for an extended period.

Criticisms of the Efficient Market Hypothesis

While the EMH has gained popularity over the years, it has not escaped criticism. Let’s explore a few of the notable criticisms surrounding this theory.

Behavioral Finance and Market Efficiency

One criticism arises from the field of behavioral finance, which suggests that investor psychology and biases can lead to predictable market anomalies. Behavioral factors such as herd mentality, overconfidence, and fear can cause market inefficiencies that contradict the EMH’s assumptions.

The Role of Market Manipulation

Another notable criticism is the argument that market manipulation can distort asset prices and undermine market efficiency. Instances of fraud, insider trading, or even market manipulation through sophisticated trading strategies can challenge the EMH’s assertion of market efficiency.

The Limits of Arbitrage

Finally, critics argue that certain barriers and costs, such as limited resources, regulatory restrictions, and short-selling constraints, can limit the ability of arbitrageurs to correct mispriced assets promptly, thereby challenging the EMH’s premise.

Wrap-up: A Personal Advice

As an expert in the field, I must emphasize that while the Efficient Market Hypothesis is a widely accepted theory, it is crucial to approach investing with caution and a healthy skepticism. Market inefficiencies can still exist and be exploited, but these opportunities are often short-lived and highly competitive. Proper diversification, understanding risk management , and staying informed with sound research are key elements to successfully navigate financial markets.

FAQ – Frequently Asked Questions

What is the efficient market hypothesis.

The Efficient Market Hypothesis suggests that financial markets are efficient and that it is impossible to consistently outperform the market and achieve above-average returns by exploiting information.

What are the three forms of market efficiency?

The three forms of market efficiency within the EMH are weak form efficiency, semi-strong form efficiency, and strong form efficiency.

What are the assumptions of the Efficient Market Hypothesis?

The EMH assumes rational investors, independent distribution of price changes, and the swift incorporation of all information into asset prices.

What are the main criticisms of the Efficient Market Hypothesis?

The EMH has been criticized for its limitations in accounting for behavioral factors, the potential impact of market manipulation, and the challenges faced by arbitrageurs in correcting mispriced assets.

I hope this comprehensive guide has shed light on the Efficient Market Hypothesis, its forms, assumptions, and criticisms. Remember, understanding the principles and limitations of this theory will help you navigate the dynamic world of finance with confidence and informed decision-making.

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Market Efficiency

There are generally two theories to assist pricing. The Efficient Market Hypothesis (EFM) and the Behavioural Finance Theory. Understanding the limitations of each of the theories is critical. Read the three concepts on this page to have a comprehensive understanding of EFM. What are the limitations of the EMH?

The Efficient Market Hypothesis

The EMH asserts that financial markets are informationally efficient with different implications in weak, semi-strong, and strong form.

Learning Objective

Differentiate between the different versions of the Efficient Market Hypothesis

• In weak-form efficiency, future prices cannot be predicted by analyzing prices from the past.
• In semi-strong-form efficiency, it is implied that share prices adjust to publicly available new information very rapidly and in an unbiased fashion, such that no excess returns can be earned by trading on that information.
• In strong-form efficiency, share prices reflect all information, public and private, and no one can earn excess returns.

A stock or commodity market analysis technique which examines only market action, such as prices, trading volume, and open interest.

An analysis of a business with the goal of financial projections in terms of income statement, financial statements and health, management and competitive advantages, and competitors and markets.

• insider trading Buying or selling securities of a publicly held company by a person who has privileged access to information concerning the company's financial condition or plans.

The efficient-market hypothesis (EMH) asserts that financial markets are "informationally efficient". In consequence of this, one cannot consistently achieve returns in excess of average market returns on a risk-adjusted basis, given the information available at the time the investment is made.

There are three major versions of the hypothesis: weak, semi-strong, and strong.

• The weak-form EMH claims that prices on traded assets (e.g., stocks, bonds, or property) already reflect all past publicly available information.
• The semi-strong-form EMH claims both that prices reflect all publicly available information and that prices instantly change to reflect new public information.
• The strong-form EMH additionally claims that prices instantly reflect even hidden or "insider" information.

Efficiency Market Hypothesis (EMH): Understanding the Pivotal Theory in Finance

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Efficiency Market Hypothesis (emh) Definition

The Efficient Market Hypothesis (EMH) is a financial theory suggesting that all available information about a particular investment, like stocks or bonds, is instantly and fully reflected in that asset’s current market price, making it nearly impossible to consistently achieve higher than average market returns through trading strategies. Essentially, it posits that markets are always perfectly efficient and it’s impossible to ‘beat the market’ because prices already incorporate and reflect all relevant information.

Understanding the Three Forms of EMH

Weak form efficiency.

The weak form of the Efficient Market Hypothesis (EMH) posits that current stock prices fully incorporate all available security market information. In essence, it indicates that past trading data, such as prices, volume of trading or rates of return, cannot be used to outperform the market. This idea fundamentally devalues the use of technical analysis, a method that uses past data for future investment decisions.

The assumptions underlining the weak form of EMH are that:

• All past market prices and data are publicly available at no cost.
• Market participants are rational and react instantaneously to any new piece of information.

Consequently, the implications are that no gains can be achieved using technical analysis. The only way to outperform (earn a higher return than) the market is by either luck or through the acquisition of inside information, which is illegal.

Semi-Strong Form Efficiency

In the semi-strong form of EMH, current stock prices do not just reflect past trading information but also all publicly available information. This includes financial statements, announcements, economic factors, and anything else accessible to the public that could potentially influence stocks.

The key assumptions in this form are that:

• All publicly available information about an asset is instantly reflected in its market price.
• No one can achieve consistently high trading returns through fundamental analysis, which involves examination of company’s financial statements and health, its management, competitors and market conditions.

This means the markets adjust quickly to absorb new information, so trading on or immediately after announcements will not lead to consistently stellar returns.

Strong Form Efficiency

The strong form of EMH claims that stock prices reflect all information, both public and private, meaning even insider information is completely factored into the market prices. In essence, no one, not even those with inside information, could have an advantage in predicting the stock prices.

Under the strong form of EMH:

• All information (public and private) is fully reflected in asset prices.
• No investor will be able to consistently achieve abnormal return in the market, neither by using past publicly available information nor inside or private information.

This implies that markets are completely efficient, and the only way to achieve higher returns consistently is by chance. This form of EMH is broader and quite controversial, given it's hard to verify and it discounts the idea that insider trading provides a beneficial edge.

Efficiency vs. Inefficiency in Market Hypothesis

In the context of economics, the terms market efficiency and market inefficiency stand in opposition to each other. They describe different states of market, where all available information gets reflected in asset prices.

In an efficient market , prices fully reflect all available information. Imagine a scenario where a company has just announced a new, hugely profitable business venture. In an efficient market, this company’s stock price would instantly adjust to reflect this positive news.

This happens because every market player has access to the same information and acts upon it without delay. In essence, you’d see no oscillation between supply and demand, meaning people couldn’t expect to consistently gain high profits from trading within an efficient market.

On the other hand, in an inefficient market , there's a lag in the reflection of available information in asset prices. Following the same scenario, if the market were inefficient, there would be a delay before that company’s stock price reflects the positive news. This delay presents an opportunity for savvy traders who've diligent enough to pay attention to the news, to buy the stock at its old, lower price, before the market adjusts and raises it.

The differentiation between these conditions primarily lies in how quickly and how accurately information gets incorporated in asset prices.

The Efficient Market Hypothesis (EMH) slots into this talk by stating that it's impossible to consistently achieve above-average profits by trading on publicly available information. Essentially, the EMH theorizes that markets are always efficient. It implies that 'beating the market' on a regular basis is nearly impossible.

While Determining Market Efficiency

Testing for market efficiency involves examining whether or not a particular market satisfies the conditions mentioned earlier. If asset prices adjust rapidly to new information and no investor can consistently achieve excess returns, then the market is deemed efficient. Conversely, if there are substantial price adjustments needed or a select few can gain profits consistently, then the market is deemed inefficient.

It's worth noting though, that while the EMH proposes markets are always efficient, the reality is that markets can fluctuate between stages of efficiency and inefficiency. These fluctuations often depend on a multitude of factors, such as accessibility to information, reaction speed of market players, and even psychological factors—elements that ensure the fascinating dynamism of economic markets.

Critiques of the Efficient Market Hypothesis

The Efficient Market Hypothesis paints an idealistic picture of financial markets, assuming they are perfectly efficient, and that prices always reflect all available information. However, this hypothesis has faced its share of critiques and controversies.

Bubbles and the Efficient Market Hypothesis

One of the most notable criticisms of EMH revolves around market bubbles. These are periods when asset prices increase dramatically and quickly, only to crash just as swiftly. Instances of stock market bubbles, housing bubbles, and dot-com bubbles have all raised questions about the validity of EMH. The dot-com bubble of the late 1990s – a period of enormous growth in internet-based companies – is a good example. During this time, stock prices soared drastically beyond what could have been justified by the future earnings prospects, contradicting the idea that prices always reflect all available information and the inherent value of an asset.

The financial crisis of 2007-2008 was another glaring example that challenged the EMH. It was marked by an unsustainable bubble in the U.S. housing market, and the subsequent crash affected financial markets globally. Both of these market anomalies suggested that market prices may not always accurately reflect underlying fundamentals.

Flash Crashes and the Efficient Market Hypothesis

In addition to market bubbles, the phenomenon of flash crashes also defies the predictions of EMH. Flash crashes refer to the sudden and dramatic plunge in stock prices in a very short time. One of the most significant flash crashes occurred on May 6, 2010, when the Dow Jones Industrial Average plunged more than 600 points within 5 minutes, only to recover a significant part of the losses very quickly. Such sudden and unexplained market swings seem at odds with the EMH, as they suggest that prices might not always reflect the true value, and can be influenced by an algorithms and high-frequency trading.

Irrational Investor Behavior

EMH also remains at odds with the concept of behavioral finance, which challenges the idea of investor rationality. Behavioral economists argue that investors' decisions are often influenced by emotional and cognitive biases, leading to irrational financial decisions that cause mispricing. For example, during times of market euphoria or panic, investors often succumb to herd mentality, buying or selling en masse, causing substantial mispricings. This notion contradicts the EMH's premise of rational investors, thereby questioning its relevance.

In conclusion, while the Efficient Market Hypothesis offers a simplified view of market functioning, the complexities of real-life financial markets, marked by bubbles, flash crashes, and irrational investor behavior, suggest a more nuanced reality.

EMH and Portfolio Theory

The integration of the Efficient Market Hypothesis with the Modern Portfolio theory is a crucial component in financial markets. In essence, the EMH assumes that all market participants have equal and immediate access to all pertinent information, thus negating the possibility of consistently outperforming the market, as all securities are always perfectly priced.

Implications for Modern Portfolio Theory

Modern Portfolio theory (MPT), on the other hand, focuses on maximizing portfolio expected return for a given amount of portfolio risk. If EMH holds true, it implies that a security's price reflects all available information, including the risk associated with it. Therefore, according to MPT, the best way to optimize a portfolio under EMH is to hold a diversified portfolio of all risky securities, colloquially known as the "market portfolio".

Asset Allocation

The combination of the EMH and MPT has significant implications for asset allocation. In an efficient market, diversifying your portfolio across broad asset classes should provide the optimal balance of risk and return. Chasing "undervalued" stocks or attempting to time the market are rendered futile exercises, since all available information is already incorporated accurately into asset prices. Therefore, the focus should be on establishing an appropriate asset mix that meets your financial goals and risk tolerance.

Risk Management

From a risk-management perspective, the EMH's incorporation within the Modern Portfolio Theory emphasizes the importance of diversification. Under this combination, the only way to reduce risk is through diversification, as all individual asset prices are fair and reflect all risk information. Investors cannot eliminate risk by picking undervalued securities, but can manage risk by holding a diversified portfolio which reduces unsystematic risk.

Overall, incorporating the Efficient Market Hypothesis into asset allocation and risk management strategies lends weight to a passive investing approach, where broad diversification, long-term holding, and a dispassionate, analytical outlook hold sway.

Implications of EMH on Corporate Finance

The Efficient Market Hypothesis (EMH) has far-reaching implications on corporate finance practices like capital budgeting, corporate governance, and financing decisions. Let's delve into each to understand better the role of EMH in corporate finance.

Capital Budgeting

The EMH suggests that all publicly available information is currently accounted for in the prices of securities. In the context of capital budgeting, this means companies cannot gain a competitive edge by timing their investments in the market or by choosing specific industries or sectors. Because all known information is presumed to be included in the current price, the future cash flows from any investment are unpredictable and should be treated as such in the budgeting process.

In effect, EMH encourages corporations to focus more on cost-effective and strategic investment planning rather than trying to outsmart the market. It underscores the need for incorporating risk analysis and scenario planning in investment decisions, rather than relying on market trends or predictions.

Corporate Governance

In the realm of corporate governance, EMH plays a crucial role. Directors and board members are expected to make decisions that are in the company's best interest. However, this can become a complex task given the supposed unpredictability of the market under EMH.

The board should ensure that the company adopts investment strategies that are not based on market forecasting or timing. It should instead look to achieve a diversified portfolio that is in alignment with the company's risk tolerance and strategic objectives. EMH encourages transparency and efficiency in internal practices since it contends that any lack of it can detrimentally affect a company's stock prices, considering all information is accountable in the market.

Financing Decisions

Finally, EMH's implications on financing decisions are profound. Since EMH proposes that stocks always trade at their fair value, it means that companies cannot rely on undervalued stocks or overvalued bonds for cheap financing. All securities are assumed to be priced correctly, reflecting all available, pertinent information.

As such, corporations need to develop their financing strategies based on interest rates, economic conditions, business opportunities, and their specific financial condition, rather than trying to beat the market. It discourages speculation in financing and encourages decisions based on sound financial principles and strategic goals.

In summary, the Efficient Market Hypothesis advocates for a systematic, rational approach to corporate finance. It highlights that financial success is not reliant on exploiting market inefficiencies, but is instead grounded in strategic planning, prudent decision-making, and efficient internal governance.

Implications of EMH in Behavioral Finance

Behavioral finance theories serve as a strong challenge to the Efficient Market Hypothesis (EMH). The central principle of these theories stipulate that market participants do not always act rationally, as the EMH presupposes, and are influenced by cognitive biases.

Influence of Cognitive Biases

A significant factor, cognitive bias, drastically diverges from the principles of the EMH. Investors, subject to cognitive biases, do not make investment decisions based solely on reliable information or act rationally. Instead, they're often swayed by their emotions, which can lead to irrational financial decision-making.

Overconfidence Bias

Overconfidence bias is a prime example of cognitive experience manipulating financial decisions. Investors, overestimating their knowledge or ability, might take unnecessary risks, driving market prices away from their true values. EMH, on the other hand, assumes all players behave rationally, neglecting the influence of human emotions.

Herd Mentality

The herd mentality describes the psychology behind the propensity for individuals to follow the masses rather than relying on their analysis or information. This bias can generate significant price changes that do not reflect accurate information about an asset's value, creating a discrepancy between the market price and intrinsic value.

Confirmation Bias

Confirmation bias refers to the inclination to seek out or interpret information that confirms existing beliefs. If prevalent, this bias could lead, over time, to a distorted market view, as investors selectively consume and comprehend information. EMH assumes that all relevant information is readily and equally accessible to all market players, something that does not align with confirmation bias.

Behavioral Finance vs EMH

In essence, behavioral finance acknowledges the often irrational, emotion-driven actions of investors, contradicting EMH's assumption of investors as rational actors. These biases can create inefficiencies in the market, distorting prices and leading them away from their true values. In such scenarios, the EMH's core principle – that securities are priced accurately, and any changes in value reflect changes in fundamental information – is challenged.

The Impact of Technology on EMH

The advent of technology, particularly machine learning and artificial intelligence, has significantly transformed financial markets. One such transformation is the rise of algorithmic trading. This technology-driven approach to trading involves pre-programmed instructions for placing trades at high speeds based on a range of variables including time, price, and volume.

The Advent of Algorithmic Trading

Algorithmic trading, also called algo-trading or black-box trading, theoretically supports the Efficient Market Hypothesis. Since EMH assumes that all information in a market is immediately exploited and prices are always fair, the high speed and efficiency of algorithmic trading seem to validate this hypothesis. Algorithmic trading allows for rapid execution of trades, making the most of available market information before it becomes widely known, thus efficiently adjusting the market price.

Information Efficiency and Technology

The role of information efficiency is crucial when discussing technological influence on EMH. Technology enhances the gathering, analyzing, and dissemination of financial information, leading to greater market efficiency. Market participants armed with sophisticated algorithmic tools have almost instant access to important information. This quick dissemination of information fosters a more easy adjustment of prices, supporting the concept of EMH as market anomalies are swiftly exploited.

However, technology also challenges the EMH. One of the foundational propositions of EMH is that all market participants have equal access to information. Yet, in the context of advanced technology and algorithmic trading, there's an informational asymmetry. Those who use sophisticated trading algorithms or have faster access to market information have an advantage over other participants. This can lead to the distortion of prices, challenging the idea of ‘fair’ prices proposed by EMH.

High Frequency Trading and EMH

Another aspect worth discussing is high frequency trading (HFT). HFT is a subset of algorithmic trading. Here, complex algorithms are used to trade financial instruments at incredibly high speeds. EMH might be challenged in scenarios where high frequency traders act on information before the broader market has a chance to react, potentially leading to artificial pricing.

Despite these challenges, technology's overall contribution to financial markets tends to lean towards increased efficiency. Even though apparent asymmetries exist, technology also democratizes access to information and trading capabilities, creating conditions for more individuals and entities to participate in financial markets and further contribute to their efficiency.

Relationship between EMH and Corporate Social Responsibility (CSR)

Despite being two entities that seem unrelated, the Efficient Market Hypothesis (EMH) and Corporate Social Responsibility (CSR) have distinct parallels that can influence a company's strategies and sustainability considerations.

EMH Implications on CSR

Beholden to EMH, a company's stock price showcases all available information, including its CSR initiatives. This suggests that every CSR act – beneficial or detrimental – reflects immediately on the company's stock value. Therefore, companies may actively strive to engage in proactive CSR strategies to maintain or increase their stock prices. This premise echoes the words of Milton Friedman, who stated, "There is one and only one social responsibility of business – to use its resources and engage in activities designed to increase its profits."

However, on the flip side, if a company’s CSR initiatives are purely profit-driven and the market perceives them as such, it might lead to a decrease in stock price, indicating EMH’s emphasis on the sincerity and effectiveness of CSR actions.

Influence of Market Efficiency on CSR Strategies

Market efficiency, which is central to EMH, plays a crucial role in shaping CSR strategies. Given that markets are efficient, companies cannot conceal their actual CSR activities and, therefore, must be upfront and transparent about their efforts. Information, after all, travels fast in efficient markets.

A transparent corporate environment can foster trust and respect among stakeholders, enhance corporate reputation, and ultimately, lead to a competitive advantage. Therefore, in efficient markets, companies might not just adopt CSR strategies that look good on paper but engage in genuine sustainable and ethical practices that add long-term value to the company.

Market Efficiency and Sustainability Considerations

Market efficiency also bears an impact on the sustainability considerations of a company. In light of EMH, firms cannot mislead investors over their long-term sustainability prospects. Therefore, companies might be incentivized to align their business operations and objectives with sustainable practices to satiate increasingly eco-conscious investors and stakeholders.

Efficient markets might punish firms that do not proactively tackle sustainability issues, which could eventually reflect in their stock prices. Similarly, companies stand to gain from stock-price appreciation if their sustainability efforts prove to be above expectations. In this manner, EMH can prompt companies to incorporate thorough sustainability practices into their management, supply chains, and overall operations.

In summary, EMH’s tenets compel firms to treat CSR and sustainability not as optional but as integral parts of their strategy. So, while EMH and CSR might appear as chalk and cheese, their symbiosis can have profound implications on the corporate world.

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• Efficient Market Theory

Written by True Tamplin, BSc, CEPF®

Reviewed by subject matter experts.

Updated on June 08, 2023

Get Any Financial Question Answered

Table of contents, what is efficient market theory (emt).

Efficient market theory (EMT) is a concept in finance that asserts that financial markets are highly efficient and that prices of assets fully reflect all available information.

EMT has been a prominent topic of debate among finance academics and practitioners since its inception.

It has been a widely studied and researched topic for decades, and its applications have had significant implications for investment decision-making, portfolio management, and market regulation.

The concept of EMT has its roots in the works of Eugene Fama , who introduced it in 1965.

EMT is grounded in the notion that market participants are rational and have access to all relevant information.

Therefore, in an efficient market, prices of securities are determined by market forces, and any new information is immediately incorporated into prices.

This implies that it is impossible to outperform the market consistently, as prices already reflect all available information.

Forms of Efficient Market Theory

EMT is commonly categorized into three forms, which include the weak form, semi-strong form, and strong form.

Weak Form: The weak form of EMT asserts that all past prices of securities are reflected in current prices, and it is impossible to use past prices to predict future prices.

Semi-strong Form: The semi-strong form of EMT suggests that current prices reflect all publicly available information, including financial statements and other disclosures.

Strong Form: The strong form of EMT suggests that current prices reflect all available information, including public and private information. In this case, insider trading would not be profitable, as prices already reflect all available information.

Empirical Evidence in Support of Efficient Market Theory

Numerous empirical studies have been conducted to test the validity of EMT.

Stock Prices Follow Random Pattern

One of the earliest and most influential studies was conducted by Fama himself. In his study, he found that stock prices in the United States followed a random walk pattern and were not predictable.

Market Prices Are Unpredictable

Other studies have found similar results, suggesting that market prices are unpredictable and follow a random walk pattern.

Actively Managed Funds Underperform

In addition, some studies have found that actively managed funds, which seek to outperform the market, often underperform the market after accounting for fees and transaction costs.

Criticisms of Efficient Market Theory

Despite the empirical evidence in support of EMT, there are several criticisms of the theory.

Investors Are Not Rational

Another criticism is that EMT assumes that all market participants are rational and have access to all relevant information. In reality, investors may not be rational, and access to information may be limited or biased.

Reflected Market Prices Are Not Always Correct

This assumption implies that the market always incorporates all relevant information into prices, which critics argue may not be true due to behavioral biases and other external factors that can impact market prices.

Prices Are Influenced by External Factors

Prices can be influenced by irrational market behavior or by external factors such as political events or natural disasters.

Behavioral Finance and Efficient Market Theory

Behavioral finance is a field of study that seeks to understand how psychological factors influence investor behavior and market outcomes.

Behavioral finance suggests that investors are not always rational and that market prices may not always reflect all available information. Therefore, behavioral finance challenges the underlying assumptions of EMT.

Behavioral finance has identified several cognitive biases that can influence investor behavior, such as overconfidence, herd mentality, and loss aversion. These biases can lead to market inefficiencies and opportunities for skilled investors to outperform the market.

Implications of Efficient Market Theory

The implications of EMT are far-reaching and have significant implications on the following:

Portfolio Management

EMT suggests that it is impossible to outperform the market consistently, and as such, active portfolio management strategies, such as stock picking and market timing are unlikely to be successful in the long run.

Instead, EMT suggests that investors should focus on passive investment strategies such as index funds that aim to replicate market performance.

Market Regulation

The implications of EMT for market regulation are also significant. If prices are always efficient, then it may not be necessary to regulate markets to ensure that prices are fair.

However, some argue that regulation is still necessary to prevent fraud and market manipulation, which can lead to market inefficiencies and undermine investor confidence.

Alternatives to Efficient Market Theory

There are several alternative theories and perspectives to EMT:

Technical Analysis

A popular approach to investing that involves analyzing past market data, such as price and volume, to predict future price movements.

Fundamental Analysis

This involves analyzing a company's financial statements, industry trends, and macroeconomic factors to determine its intrinsic value .

Value Investing

This strategy involves identifying undervalued securities and investing in them with the expectation that their value will increase over time.

Final Thoughts

Efficient Market Theory is a cornerstone of financial economics, positing that financial markets are efficient and that asset prices reflect all available information.

The concept has significant implications for investment decision-making, portfolio management, and market regulation.

However, the debate surrounding EMT remains ongoing, with some scholars pointing to empirical evidence that supports the theory while others criticize its underlying assumptions.

Despite the criticisms, the concept of EMT continues to be relevant in financial markets today. Investors must carefully consider the underlying assumptions of the theory and alternative approaches to investing when making investment decisions.

Understanding the implications of EMT for investment decision-making, portfolio management, and market regulation is critical to success in today's financial markets.

While EMT has limitations, it remains a valuable tool for understanding the behavior of financial markets and the pricing of financial assets. For more information on efficient market theory and support in applying it to your circumstances, you may consult a wealth management professional.

Efficient Market Theory FAQs

What is efficient market theory.

Efficient market theory is a concept in finance that asserts that financial markets are highly efficient and that prices of assets fully reflect all available information.

What are the forms of efficient market theory?

Is there empirical evidence to support efficient market theory.

Numerous empirical studies have been conducted to test the validity of EMT. Some studies have found evidence in support of EMT, while others have found evidence that contradicts the theory.

What are the criticisms of efficient market theory?

The criticisms of EMT center around the difficulty in defining what constitutes relevant information, the assumption that all market participants are rational and have access to all relevant information, and the assumption that market prices are always correct.

What are the implications of efficient market theory for investment decision-making?

EMT suggests that it is impossible to outperform the market consistently, and as such, active portfolio management strategies such as stock picking and market timing are unlikely to be successful in the long run. Instead, EMT suggests that investors should focus on passive investment strategies, such as index funds that aim to replicate market performance.

About the Author

True Tamplin, BSc, CEPF®

True Tamplin is a published author, public speaker, CEO of UpDigital, and founder of Finance Strategists.

True is a Certified Educator in Personal Finance (CEPF®), author of The Handy Financial Ratios Guide , a member of the Society for Advancing Business Editing and Writing, contributes to his financial education site, Finance Strategists, and has spoken to various financial communities such as the CFA Institute, as well as university students like his Alma mater, Biola University , where he received a bachelor of science in business and data analytics.

To learn more about True, visit his personal website or view his author profiles on Amazon , Nasdaq and Forbes .

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Quickonomics

Efficient Market Hypothesis

Definition of efficient market hypothesis.

The Efficient Market Hypothesis (EMH) is an investment theory that states that it is impossible to “beat the market” because stock market efficiency causes existing share prices to always incorporate and reflect all relevant information. That means stock prices always reflect all available information, and it is impossible to consistently outperform the market by using any information that is already available.

Note that different versions of the EMH exist, depending on the types of information included and their effects on market efficiency. For more information, check out our post on the three versions of the Efficient Market Hypothesis .

To illustrate this, let’s look at a hypothetical investor called John. John is an experienced trader who has been trading stocks for many years. He has access to the same information as everyone else, such as company financials, analyst reports, and news articles. He also has a good understanding of the stock market and is able to make informed decisions.

However, despite all his knowledge and experience, John can still not outperform the market consistently. This is because the stock prices already reflect all the available information (i.e., everyone else knows it too). Thus, even though John may be able to make a few successful trades, he will not be able to beat the market in the long run consistently.

Why Efficient Market Hypothesis Matters

The Efficient Market Hypothesis is an important concept for investors to understand. It helps them to understand why it is so difficult to outperform the market consistently. It also explains why it is essential to diversify investments and why it is vital to have a long-term investment strategy. Finally, it also serves as a reminder that no one has the edge over the market, and that it is impossible to predict the future.

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Efficient Markets Hypothesis (EMH)

EMH Definition and Forms

What Is Efficient Market Hypothesis?

What are the types of emh, emh and investing strategies, the bottom line, frequently asked questions (faqs).

The Efficient Market Hypothesis (EMH) is one of the main reasons some investors may choose a passive investing strategy. It helps to explain the valid rationale of buying these passive mutual funds and exchange-traded funds (ETFs).

The Efficient Market Hypothesis (EMH) essentially says that all known information about investment securities, such as stocks, is already factored into the prices of those securities. If that is true, no amount of analysis can give you an edge over "the market."

EMH does not require that investors be rational; it says that individual investors will act randomly. But as a whole, the market is always "right." In simple terms, "efficient" implies "normal."

For example, an unusual reaction to unusual information is normal. If a crowd suddenly starts running in one direction, it's normal for you to run that way as well, even if there isn't a rational reason for doing so.

There are three forms of EMH: weak, semi-strong, and strong. Here's what each says about the market.

• Weak Form EMH:  Weak form EMH suggests that all past information is priced into securities. Fundamental analysis of securities can provide you with information to produce returns above market averages in the short term. But no "patterns" exist. Therefore, fundamental analysis does not provide a long-term advantage, and technical analysis will not work.
• Semi-Strong Form EMH:  Semi-strong form EMH implies that neither fundamental analysis nor technical analysis can provide you with an advantage. It also suggests that new information is instantly priced into securities.
• Strong Form EMH:  Strong form EMH says that all information, both public and private, is priced into stocks; therefore, no investor can gain advantage over the market as a whole. Strong form EMH does not say it's impossible to get an abnormally high return. That's because there are always outliers included in the averages.

EMH does not say that you can never outperform the market . It says that there are outliers who can beat the market averages. But there are also outliers who lose big to the market. The majority is closer to the median. Those who "win" are lucky; those who "lose" are unlucky.

Proponents of EMH, even in its weak form, often invest in index funds or certain ETFs. That is because those funds are passively managed and simply attempt to match, not beat, overall market returns.

Index investors might say they are going along with this common saying: "If you can't beat 'em, join 'em." Instead of trying to beat the market, they will buy an index fund that invests in the same securities as the benchmark index.

Some investors will still try to beat the market, believing that the movement of stock prices can be predicted, at least to some degree. For that reason, EMH does not align with a day trading strategy. Traders study short-term trends and patterns. Then, they attempt to figure out when to buy and sell based on these patterns. Day traders would reject the strong form of EMH.

For more on EMH, including arguments against it, check out the EMH paper from economist Burton G. Malkiel. Malkiel is also the author of the investing book "A Random Walk Down Main Street." The random walk theory says that movements in stock prices are random.

If you believe that you can't predict the stock market, you would most often support the EMH. But a short-term trader might reject the ideas put forth by EMH, because they believe that they are able to predict changes in stock prices.

For most investors, a passive, buy-and-hold , long-term strategy is useful. Capital markets are mostly unpredictable with random up and down movements in price.

When did the Efficient Market Hypothesis first emerge?

At the core of EMH is the theory that, in general, even professional traders are unable to beat the market in the long term with fundamental or technical analysis . That idea has roots in the 19th century and the "random walk" stock theory. EMH as a specific title is sometimes attributed to Eugene Fama's 1970 paper "Efficient Capital Markets: A Review of Theory and Empirical Work."

How is the Efficient Market Hypothesis used in the real world?

Investors who utilize EMH in their real-world portfolios are likely to make fewer decisions than investors who use fundamental or technical analysis. They are more likely to simply invest in broad market products, such as S&P 500 and total market funds.

Corporate Finance Institute. " Efficient Markets Hypothesis ."

IG.com. " Random Walk Theory Definition ."

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Efficient Market Hypothesis

Built-in accuracy, how does an efficient market affect investors.

When people talk about market efficiency , they are referring to the degree to which the aggregate decisions of all market participants accurately reflect the value of public companies and their common shares at any given moment in time. This requires determining a company's intrinsic value and constantly updating those valuations as new information becomes known. The faster and more accurate the market is able to price securities, the more efficient it is said to be.

Key Takeaways

• If a market is efficient, it means that market prices currently and accurately reflect all information available to all interested parties.
• If the above is true, there is no way to systematically "beat" the market and profit from mispricings, since they would never exist.
• An efficient market would benefit passive index investors most.

This principle is called the Efficient Market Hypothesis (EMH) , which asserts that the market is able to correctly price securities in a timely manner based on the latest information available. Based on this principle, there are no undervalued stocks to be had, since every stock is always trading at a price equal to its intrinsic value.

There are several versions of EMH that determine just how strict the assumptions needed to hold to make it true are. However, the theory has its detractors, who believe the market overreacts to economic changes, resulting in stocks becoming overpriced or underpriced, and they have their own historical data to back it up.  

For example, consider the boom (and subsequent bust) of the dot-com bubble in the late 1990s and early 2000s. Countless technology companies (many of which had not even turned a profit) were driven up to unreasonable price levels by an overly bullish market . It was a year or two before the bubble burst, or the market adjusted itself, which can be seen as evidence that the market is not entirely efficient—at least, not all of the time.

In fact, it is not uncommon for a given stock to experience an upward spike in a short period, only to fall back down again (sometimes even within the same trading day). Surely, these types of price movements do not entirely support the efficient market hypothesis.

The implication of EMH is that investors shouldn't be able to beat the market because all information that could predict performance is already built into the stock price. It is assumed that stock prices follow a  random walk , meaning that they're determined by today's news rather than past stock price movements.

It is reasonable to conclude that the market is considerably efficient most of the time. However, history has proved that the market can overreact to new information (both positively and negatively). As an individual investor, the best thing you can do to ensure you pay an accurate price for your shares is to research a company before purchasing their stock and analyze whether or not the market appears to be reasonable in its pricing .

New York University. " What Is an Efficient Market? "

Nasdaq. " Efficient Market Hypothesis ."

University of West Georgia. " The Efficient Market Hypothesis on Trial: A Survey ."

Britannica. " Dot-Com Bubble ."

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