what does efficient market hypothesis mean

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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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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Efficient Market Hypothesis

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The efficient market hypothesis is a theory that market prices fully reflect all available information, i.e. that market assets, like stocks , are worth what their price is. The theory suggests that it's impossible for any individual investor to leverage superior intelligence or information to outperform the market, since markets should react to information and adjust themselves. Any intelligent investor buying a stock is doing so because they believe the stock is worth more than the data (typically historical returns, projected returns, macroeconomic trends , industry trends, etc.) support it being worth. They think that the data is wrong and undervaluing the stock. Economists counter that investors are either buying riskier stocks and undervaluing the risk or succeeding through chance. Put another way, as Burton Malkiel says in his book, A Random Walk Down Wall Street , the efficient market hypothesis means that "a blindfolded chimpanzee throwing darts at the Wall Street Journal could select a portfolio that would do as well as the experts."

As this, essentially, suggests that the tens of thousands of experts who work as active investors are worthless, it has been heavily critiqued. These critiques, themselves, come from successful investors like Warren Buffett who points to the undervaluing of "value stocks" (as opposed to the sexier growth stocks), behavioral economists who point to humanity's inefficiencies, and experts who have used valuations techniques, like dividend yields and price-earnings ratios to generate higher returns.

French mathematician, Louis Bachelier is considered to many to be the first to apply probability theory to markets. [1] Though his work didn't reach a wide audience until the 1950s and 1960s. Eugene Fama is credited, over the course of his career, for much of modern theories of efficient markets, expanding Bachelier's initial work, and starting with Fama's publication, in 1965 of his PhD thesis. Both used mathematical models of random walks and were influenced by Hayek's 1945 argument that markets are the most efficient way to aggregate information.

Weak, Semi-Strong, and Strong Efficiency

Attacks (and responses to attacks) on the efficient market hypothesis, response to attacks on the efficient market hypothesis, how stocks respond to interest rates, investment strategies for proponents of the efficient market hypothesis, possible paradoxes.

Efficient markets are said to exist in varying degrees of efficiency, generally categorized as weak, semi-strong, and strong. These degrees of strength pertain markets responding to information.

In strong efficiency markets, all public and private information is reflected in market prices. This includes insider information (and thus if there are laws prohibiting insider information from being made public, strong efficiency is not in place). In such a market investors, overall, cannot earn excess returns because the market has priced in historical and future (trend) information. Those individual investors are said to consistently outperform the market, maybe doing so simply because any log-normal distribution of thousands of fund managers will include some that consistently outperform the average.

In semi-strong efficiency markets, investors respond very quickly to new information. Because of the speed of information being responded to, investors cannot make excess returns from information. (There are cases where investors set up communications networks to arbitrage information faster than other investors could, but this is a market inefficiency that was corrected for over time). The contention around semi-strong markets is that they have factored in all available information, so fundamental and technical analysis (i.e. doing analysis from available information) does not reveal underpriced securities for investors to make excess returns from.

In weak efficiency markets, there is a chance that investors can make some money in the short term, that markets only reflect all currently available information in the long term. However, markets do, eventually, reflect all available information, and it contends that historical data does not have a relationship with future prices, i.e. Investors cannot use past data to predict future prices and gain excess returns.

There is one anomaly to weak efficiency, one that even Fama has acknowledged, and that has been observed in multiple international markets: the momentum effect. Stocks that have historically gone up in the past 3-12 months, tend to continue to go up. Stocks that have historically gone down in the past 3-12 months, tend to continue to go down.

Behavioral Economics Behavioral economists (and behavioral psychologists) study the cognitive bias that humans have and that lead to irrational decision making. At a high level, these biases could prove that investors are inefficient, both signaling that they aren't going to beat the market (consistent with EMH) and that there are arbitrage opportunities to exploit their inefficiencies (inconsistent with EMH). For instance, people have been shown to employ something called hyperbolic discounting, i.e. given two rewards, humans tend to prefer the reward that comes sooner to the one that comes later. And investment fund managers can suffer from this same bias; in some cases their bonus this year is predicated on their returns this year, not their long-term returns, potentially leading to making okay short-term decisions at the expense of great long-term options. Other economists point to herd mentality , loss aversion , and the sunk cost fallacy for reasons why investors will not outperform the market.

Bubbles Stock market bubbles--like the dot-com bubble of the late 90s, and the housing market bubble of the early 2000s--are acknowledged analomies in the EMH. For a period of time markets (and investors) systematically overestimated a set of assets, until they came crashing down. Economists contend that even rare statistical events are allowed under log-normal distributions. But investors counter that there is an arbitrage opportunity here--that some savvy investors made money by realizing these assets were inflated, and that once the market crashed, the assets were deflated. Economists, in turn, counter back that it's hard or abnormal to realize this in real time, and that few investors arbitraged successfully. For instance, in the case of the dot-com bubble, the available information actually supported some of the prevailing high valuations. With internet usage doubling every few months, one could conceive that this would continue (as it inevitably did with a handful of dot-com era companies--Amazon, Ebay, Yahoo--deservedly achieving the same or higher valuations that they had back in the late 90s).

Successful Investors and Value Investing Some notable investors, Warren Buffett being one, contend that investment techniques, like value investing , have let them outperform the market, even when most other investors do only as well as index funds would. Value investing is a technique, pioneered by Benjamin Graham and David Dodd, in which the investor, generally, buys securities that are underpriced according to some form of analysis (see dividend yields and P/E ratios below).

In a famous 1984 lecture at Columbia Business School, Warren Buffett talked about nine successful investors that are not merely statistically outliers on a log-normal distribution curve of efficient markets, “So these are nine records of 'coin-flippers' from Graham-and-Doddsville. I haven’t selected them with hindsight from among thousands. It’s not like I am reciting to you the names of a bunch of lottery winners...I selected these men years ago based upon their framework for investment decision-making...It’s very important to understand that this group has assumed far less risk than average; note their record in years when the general market was weak. While they differ greatly in style, these investors are, mentally, always buying the business, not buying the stock. A few of them sometimes buy whole businesses. Far more often they simply buy small pieces of businesses. Their attitude, whether buying all or a tiny piece of a business, is the same. Some of them hold portfolios with dozens of stocks; others concentrate on a handful. But all exploit the difference between the market price of a business and its intrinsic value.”

These, and other value investors, look at fundamental analysis like the following to determine predictable patters: Bar graph of 10-year stock returns grouped by dividend yields [2]

Have high dividend yields : Dividends are cash returns that companies choose to pass on to their shareholders. For instance a company might return $100 million to it's shareholders by giving $1 for each of the 1 million shares outstanding. The chart to the right takes the dividend yield of the S&P 500 each quarter from 1926 - 1990 and then finds the ten-year return (through 2000). It shows that investors have earned a greater rate of return from high-dividend yielding stocks. However, as Malkiel notes: "These findings are not necessarily inconsistent with efficiency. Dividend yields of stocks tend to be high when interest rates are high, and they tend to be low when interest rates are low (see below ). Consequently, the ability of initial yields to predict returns may simply reflect the adjustment of the stock market to general economic conditions. Moreover, the use of dividend yields to predict future returns has been ineffective since the mid-1980s. Dividend yields have been at the three percent level or below continuously since the mid-1980s, indicating very low forecasted returns." [2] This low-dividend trend has continued through the 21st century, with many companies electing for share repurchases as a theoretically "better way" to return capital to investors. Bar graph of 10-year stock returns grouped by P/E ratios [2]

Have low price-to-earning multiples or have low price-to-book ratios (P/E ratios): Another favored metric of value investors is the Price to earnings ratio. Some companies, like Facebook, have relatively high multiples of earnings, as of December 1st 2016, it was \(\approx 44\) meaning that the total return Facebook earned for the previous four quarters was \(\frac{1}{44}\)th of the stock price. Or, put another way, it would take 44 years, at the current rate of net earnings for Facebook to pay an investor back for their purchase price. The key here being that investors who are choosing to buy Facebook believe those earnings will increase. However the size of this P/E ratio would, traditionally, make it not a good candidate for value investors. In the chart to the right, S&P 500 stocks are grouped by their quarterly P/E ratios from 1926 - 1990 and then the average of their ten-year return (through 2000) is calculated. Stocks with P/E ratios under 9.9 outperformed others in this study, and are generally considered "value stocks" or stocks bought "at a discount". The famous saying for value investors is "buy low, sell high" or buy when the stock is undervalued, sell when it's at par or overvalued. Where the advocate of the efficient market hypothesis would respond that the market prices in all information stocks will only be temporarily under or over valued.

The primary evidence for the efficient market hypothesis is the preponderance of studies showing that active investors do not outperform the market. There is a substantial body of work showing that mutual fund managers do not outperform the market [3] [4] [5] [6] . This is even true for investors that have performed well in the past. Like stocks, past performance is not an indicator of future success. And many have concluded that the fees that investment advisors charge cause their customers to underperform the market overall.

A number of studies have specifically looked at how the market responses to new information , theorizing that if it is an efficient market individual announcements should not, on average, raise the price of stocks because this information would already be priced in. [7] [8]

Fama's response to significant anomalies , where the market over or under reacts, is that "an efficient market generates categories of events that individually suggest that prices over-react to information. But in an efficient market, apparent underreaction will be about as frequent as overreaction. If anomalies split randomly between underreaction and overreaction, they are consistent with market efficiency." "The important point is that the literature does not lean cleanly toward either [over or under reaction] as the behavioral alternative to market efficiency. "

Stocks are highly sensitive to interest rates. If low-risk government bonds general significantly high levels of interest, investors will prefer them to their risky stock alternatives. As such, stock prices can go up or down based on interest rate prices (again the market should price in expectations about whether interest rates will change). As an example, suppose that stocks are priced as the present value of the expected future stream of dividends: \[r = \frac{D}{P} + g\] Where \(r\) is the rate of return, \(D\) is the dividend yield, \(P\) is the price, and \(g\) is the growth rate.

Suppose the "riskless rate" on government securities is 4%, and the risk premium on equity investments is 2%. Also suppose that there is a stock that is expected to have a growth rate of 2% and a dividend of $2 per share, what should the equity be priced at? This expected rate of return, if the interest rate is 4% and the risk premium is 2%, would be 6%. And formula is as follows: \(r = \frac{D}{P} + g\) \(0.06 = $2.00/P + 0.02\) \(0.04 = $2.00/P\) \(P = $2.00/0.04 = $50.00\) The equity should be priced at $50.

In the example on the efficient market hypothesis wiki, we said that in a market where the "riskless rate" is 4%, the risk premium is 2%, the dividend yield is $2, and the expected growth rate is 2% then the stock, priced only as the present value of the expected value of the stream of future dividends, should be worth $50.00. This follows from the formula: \[r= \frac{D}{P} + g\] What happens when the interest rate rises to 5%? How much should the stock price increase or decrease if nothing else changes?

The principal suggestion from Efficient Market Hypothesis Advocates is to minimize costs (both fees and taxes if possible). Warren Buffett himself has agreed that most investors do not outperform the market, saying in his 2013 letter [9] that after his passing, his money will be invested for his family in the following way: "10% of the cash in short-term government bonds and 90% in a very low-cost S&P 500 index fund. (I suggest Vanguard’s.) I believe the trust’s long-term results from this policy will be superior to those attained by most investors--whether pension funds, institutions or individuals--who employ high-fee managers."

In general, large institutions (pension funds, endowments, foundations, etc.) have followed this advice and have been shifting from actively managed funds to passively managed ones . According to Morningstar's 2015 Annual report, " In 2015, actively managed mutual funds suffered more than $200 billion of net outflows, compared with net inflows of more than $400 billion for passively managed funds." [10]

In private, some active investors gleefully appreciate the spread of the Efficient Market Hypothesis and the shift to passively managed funds. Because the fewer people actively managing funds means fewer people to compete with. They would argue that active managers play a role in ensuring market efficiency and with fewer active managers the market will become less efficient, presenting the few that are left with more opportunities. I.E. that as more people believe in the efficient market hypothesis and passively manage their funds in indexes, the markets will become less efficient and open up opportunities for active money managers.

Overall, some consider the whole theory something of a paradox. Statistically it seems valid, but there are numerous anomalies and numerous investors with long term periods of success (for instance Berkshire Hathaway's 51 year compound annual return is 19-20% a year versus the S&P's 9.7%). There is compelling evidence on both sides, but one of the greatest advantages the theory has propelled is to point out investors' historical overreliance on investment professionals and the massive industry predicated on this need.

• Bachelier, L. The Theory of Speculation . Retrieved December 1st 2016, from http://press.princeton.edu/chapters/s8275.pdf
• Malkiel, B. The Efficient Market Hypothesis and Its Critics . Retrieved December 1st 2016, from http://www.princeton.edu/ceps/workingpapers/91malkiel.pdf
• Jensen, M. The Performance of Mutual Funds in the Period 1945-1964 . Retrieved November 23rd 2016, from http://www.e-m-h.org/Jens68.pdf
• Fama, E. Efficient Capital Markets: A Review of Theory and Empirical Work . Retrieved November 23rd, 2016, from http://www.jstor.org/stable/2325486
• Fama, E. Efficient Capital Markets: II . Retrieved November 23rd 2016, from http://faculty.chicagobooth.edu/jeffrey.russell/teaching/Finecon/readings/fama.pdf
• Sommer, J. Who Routinely Trounces the Stock Market? Try 2 Out of 2,862 Funds . Retrieved November 23rd 2016, from http://www.nytimes.com/2014/07/20/your-money/who-routinely-trounces-the-stock-market-try-2-out-of-2862-funds.html
• Ball, R., & Brown, P. An Empirical Evaluation of Accounting Income Numbers . Retrieved December 1st 2016, from http://www.drthomaswu.com/uicfat/1.pdf
• Fama, E., Fisher, L., Jensen, M., & Roll, R. The Adjustment of Stock Prices to New Information . Retrieved December 1st 2016, from https://www.jstor.org/stable/2525569?seq=1#page_scan_tab_contents
• Hathaway, B. Berkshire Hathaway . Retrieved November 29th 2016, from http://www.berkshirehathaway.com/letters/2013ltr.pdf
• Morningstar, . 2015 Annual Report . Retrieved December 1st 2106, from https://corporate.morningstar.com/us/documents/PR/Morningstar-Annual-Report-2015.pdf

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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 ."

Efficient Market Hypothesis (EMH)

Written by True Tamplin, BSc, CEPF®

Reviewed by subject matter experts.

Updated on July 12, 2023

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Table of contents, efficient market hypothesis (emh) overview.

The Efficient Market Hypothesis (EMH) is a theory that suggests financial markets are efficient and incorporate all available information into asset prices.

According to the EMH, it is impossible to consistently outperform the market by employing strategies such as technical analysis or fundamental analysis.

The hypothesis argues that since all relevant information is already reflected in stock prices, it is not possible to gain an advantage and generate abnormal returns through stock picking or market timing.

The EMH comes in three forms: weak, semi-strong, and strong, each representing different levels of market efficiency.

While the EMH has faced criticisms and challenges, it remains a prominent theory in finance that has significant implications for investors and market participants.

Types of Efficient Market Hypothesis

The Efficient Market Hypothesis can be categorized into the following:

Weak Form EMH

The weak form of EMH posits that all past market prices and data are fully reflected in current stock prices.

Therefore, technical analysis methods, which rely on historical data, are deemed useless as they cannot provide investors with a competitive edge. However, this form doesn't deny the potential value of fundamental analysis.

Semi-strong Form EMH

The semi-strong form of EMH extends beyond historical prices and suggests that all publicly available information is instantly priced into the market.

This includes financial statements, news releases, economic indicators, and other public disclosures. Therefore, neither technical analysis nor fundamental analysis can yield superior returns consistently.

Strong Form EMH

The most extreme version of EMH, the strong form, asserts that all information, both public and private, is fully reflected in stock prices.

Even insiders with privileged information cannot consistently achieve higher-than-average market returns. This form, however, is widely criticized as it conflicts with securities regulations that prohibit insider trading .

Assumptions of the Efficient Market Hypothesis

Three fundamental assumptions underpin the Efficient Market Hypothesis.

All Investors Have Access to All Publicly Available Information

This assumption holds that the dissemination of information is perfect and instantaneous. All market participants receive all relevant news and data about a security or market simultaneously, and no investor has privileged access to information.

All Investors Have a Rational Expectation

In EMH, it is assumed that investors collectively have a rational expectation about future market movements. This means that they will act in a way that maximizes their profits based on available information, and their collective actions will cause securities' prices to adjust appropriately.

Investors React Instantly to New Information

In an efficient market, investors instantaneously incorporate new information into their investment decisions. This immediate response to news and data leads to swift adjustments in securities' prices, rendering it impossible to "beat the market."

Implications of the Efficient Market Hypothesis

The EMH has several implications across different areas of finance.

Implications for Individual Investors

For individual investors, EMH suggests that "beating the market" consistently is virtually impossible. Instead, investors are advised to invest in a well-diversified portfolio that mirrors the market, such as index funds.

Implications for Portfolio Managers

For portfolio managers , EMH implies that active management strategies are unlikely to outperform passive strategies consistently. It discourages the pursuit of " undervalued " stocks or timing the market.

Implications for Corporate Finance

In corporate finance, EMH implies that a company's stock is always fairly priced, meaning it should be indifferent between issuing debt and equity . It also suggests that stock splits , dividends , and other financial decisions have no impact on a company's value.

Implications for Government Regulation

For regulators , EMH supports policies that promote transparency and information dissemination. It also justifies the prohibition of insider trading.

Criticisms and Controversies Surrounding the Efficient Market Hypothesis

Despite its widespread acceptance, the EMH has attracted significant criticism and controversy.

Behavioral Finance and the Challenge to EMH

Behavioral finance argues against the notion of investor rationality assumed by EMH. It suggests that cognitive biases often lead to irrational decisions, resulting in mispriced securities.

Examples include overconfidence, anchoring, loss aversion, and herd mentality, all of which can lead to market anomalies.

Market Anomalies and Inefficiencies

EMH struggles to explain various market anomalies and inefficiencies. For instance, the "January effect," where stocks tend to perform better in January, contradicts the EMH.

Similarly, the "momentum effect" suggests that stocks that have performed well recently tend to continue performing well, which also challenges EMH.

Financial Crises and the Question of Market Efficiency

The Global Financial Crisis of 2008 raised serious questions about market efficiency. The catastrophic market failure suggested that markets might not always price securities accurately, casting doubt on the validity of EMH.

Empirical Evidence of the Efficient Market Hypothesis

Empirical evidence on the EMH is mixed, with some studies supporting the hypothesis and others refuting it.

Evidence Supporting EMH

Several studies have found that professional fund managers, on average, do not outperform the market after accounting for fees and expenses.

This finding supports the semi-strong form of EMH. Similarly, numerous studies have shown that stock prices tend to follow a random walk, supporting the weak form of EMH.

Evidence Against EMH

Conversely, other studies have documented persistent market anomalies that contradict EMH.

The previously mentioned January and momentum effects are examples of such anomalies. Moreover, the occurrence of financial bubbles and crashes provides strong evidence against the strong form of EMH.

Efficient Market Hypothesis in Modern Finance

Despite criticisms, the EMH continues to shape modern finance in profound ways.

EMH and the Rise of Passive Investing

The EMH has been a driving force behind the rise of passive investing. If markets are efficient and all information is already priced into securities, then active management cannot consistently outperform the market.

As a result, many investors have turned to passive strategies, such as index funds and ETFs .

Impact of Technology on Market Efficiency

Advances in technology have significantly improved the speed and efficiency of information dissemination, arguably making markets more efficient. High-frequency trading and algorithmic trading are now commonplace, further reducing the possibility of beating the market.

Future of EMH in Light of Evolving Financial Markets

While the debate over market efficiency continues, the growing influence of machine learning and artificial intelligence in finance could further challenge the EMH.

These technologies have the potential to identify and exploit subtle patterns and relationships that human investors might miss, potentially leading to market inefficiencies.

The Efficient Market Hypothesis is a crucial financial theory positing that all available information is reflected in market prices, making it impossible to consistently outperform the market. It manifests in three forms, each with distinct implications.

The weak form asserts that all historical market information is accounted for in current prices, suggesting technical analysis is futile.

The semi-strong form extends this to all publicly available information, rendering both technical and fundamental analysis ineffective.

The strongest form includes even insider information, making all efforts to beat the market futile. EMH's implications are profound, affecting individual investors, portfolio managers, corporate finance decisions, and government regulations.

Despite criticisms and evidence of market inefficiencies, EMH remains a cornerstone of modern finance, shaping investment strategies and financial policies.

Efficient Market Hypothesis (EMH) FAQs

What is the efficient market hypothesis (emh), and why is it important.

The Efficient Market Hypothesis (EMH) is a theory suggesting that financial markets are perfectly efficient, meaning that all securities are fairly priced as their prices reflect all available public information. It's important because it forms the basis for many investment strategies and regulatory policies.

What are the three forms of the Efficient Market Hypothesis (EMH)?

The three forms of the EMH are the weak form, semi-strong form, and strong form. The weak form suggests that all past market prices are reflected in current prices. The semi-strong form posits that all publicly available information is instantly priced into the market. The strong form asserts that all information, both public and private, is fully reflected in stock prices.

How does the Efficient Market Hypothesis (EMH) impact individual investors and portfolio managers?

According to the EMH, consistently outperforming the market is virtually impossible because all available information is already factored into the prices of securities. Therefore, it suggests that individual investors and portfolio managers should focus on creating well-diversified portfolios that mirror the market rather than trying to beat the market.

What are some criticisms of the Efficient Market Hypothesis (EMH)?

Criticisms of the EMH often come from behavioral finance, which argues that cognitive biases can lead investors to make irrational decisions, resulting in mispriced securities. Additionally, the EMH has difficulty explaining certain market anomalies, such as the "January effect" or the "momentum effect." The occurrence of financial crises also raises questions about the validity of EMH.

How does the Efficient Market Hypothesis (EMH) influence modern finance and its future?

Despite criticisms, the EMH has profoundly shaped modern finance. It has driven the rise of passive investing and influenced the development of many financial regulations. With advances in technology, the speed and efficiency of information dissemination have increased, arguably making markets more efficient. Looking forward, the growing influence of artificial intelligence and machine learning could further challenge the EMH.

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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What is the Efficient Market Hypothesis (EMH)?

Home › Economics › Macroeconomics › What is the Efficient Market Hypothesis (EMH)?

Definition:  The efficient market hypothesis (EMH) is an investment theory launched by Eugene Fama, which holds that investors, who buy securities at efficient prices, should be provided with accurate information and should receive a rate of return that implicitly includes the perceived risk of the security.

• What Does Efficient Market Hypothesis Mean?

Summary Definition

What is the definition of efficient market hypothesis?  The intrinsic value of security is the  present value  of the expected  cash flows  that the investment will generate in the future. The market reflects all newly available information in the  market price  so investors can accurately forecast the expected future value.

The term “new information” implies information that could not be predicted, because, in this case, it would have been integrated into the market price. In this aspect, securities trade at their fair value protecting investors from buying undervalued  stocks  or selling overvalued stocks. On the other hand, the only possible way to outperform an efficient market is to accept a higher level of  investment risk .

Let’s look at an example.

Peter holds 850 shares of a technology company that currently trade at $125.36 per share. His best friend, who is an insider in the company, informs Peter that the stock price will decline over the next days because the company has failed in a project.

Peter does not believe his friend and holds all his shares. A week later, the technology company announces the failure of the deal, and the stock price starts declining sharply, dropping to $105.12 in a couple of days.

The market is efficient and adjusts immediately to the newly available information – in this case, the company’s announcement about the failed deal. To realize a gross gain, Peter should have sold some of his shares at $125.36 per share as soon as the market adjusted to the newly available information. Instead, he held all his shares, thus losing money.

If Peter had sold 400 shares at $125.36 per share, he would realize a gross gain of $50,144. Now that he held all his 850 shares, his loss is 850 x $125.36 – 850 x $105.12 = $106,556 – $89,352 = $17,204.

Define Efficient Market Hypothesis:  Efficient market theory means a that investors should earn a return on their investments according to their perceived risk at the time of investment.

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What is the efficient market hypothesis and what does it mean for you.

• Bob French, CFA

Navigating the financial markets can often feel like you’re in a labyrinth, with news outlets, analysts, and every ‘guru’ on the internet vying for your attention, each one painting a picture of the market landscape teeming with endless opportunities for extraordinary gains (or horrific losses). But there’s an easy way for investors (whether you’re focused on retirement or not) to cut through the noise.

The financial markets absolutely are monstrously complex things. Pretty much everything that you can imagine goes into the markets – and drives security prices. And we can largely ignore all of it because of something called the Efficient Market Hypothesis.

What is the Efficient Market Hypothesis and Why It Matters to You

You may have heard of the Efficient Market Hypothesis (often abbreviated as the EMH) before. It’s one of those things that a lot of people are vaguely aware of (and trotted out when they want to sound smart), but it’s also pretty widely misunderstood – often especially by the people who think they do understand it.

At its core, the Efficient Market Hypothesis, developed by Eugene Fama at the University of Chicago (in a shockingly readable paper ), says that financial markets are beset with such ferocious competition that their prices reflect all available information at any given point in time. In other words, there are so many people constantly buying and selling that everything that everyone knows – facts about the company, what’s going on in the economy, how people feel about both the company and economy, what people think will happen next, what they think other people think will happen next (I’m watching you Vizzini), and everything else – goes into a security’s price. And this means that, unless you know something different than literally everyone else in the world, it’s all but impossible to consistently beat the market.

It’s also, to use a slightly technical term, the null hypothesis of finance. The EMH is the baseline of finance. Essentially, if someone thinks the markets are not efficient, the burden of proof is on them to prove it. And if it’s not true, it should be pretty easy to disprove – you just need to show how to consistently beat the market. But we’re still waiting on that .

Deciphering the Efficient Market Hypothesis

A good place to start picking apart the idea of market efficiency is by thinking about what “all available information” really means. First up, it doesn’t mean that markets are perfect (if that’s even a meaningful concept – though we’ll come back to this).

It does mean that market prices are our best guess of what a company is actually worth based on what we currently know. But we also know that our best guess isn’t quite right. Or put more directly, we know that it’s wrong. Problem is, we don’t know if the price is wrong because it’s too high, or too low. You can think of a security’s price as the midpoint of the market’s expectations.

But let’s back up a second and think about how market prices are actually set. There’s no entity determining the value of a security. The market price is really just the last price that a security traded for. It’s just the most recent time that a buyer and seller matched. But let’s think about this a bit more.

Prices are based on what people are willing to pay for a security – all of the market participants in the world trading billions of dollars trying to be right.

And they really care about getting it right because they have their own money on the line.

They are building these wildly complex models trying to predict that “true” value of a security (or just going off a hunch), and then they are basing their trading on the results. If they think that Amazon is overpriced, they’ll start selling. And if enough people agree, then the price of Amazon will start coming down. If they think that Amazon is under priced, then they’ll start buying – driving the price up.

This self correcting process is both the magic of the markets, and the mechanism for how markets can be efficient. But so far we’re only talking about a single point in time. How do prices move?

Markets Move on Updated Information

Once the markets arrive at a price, something needs to happen for that price to move. If a stock’s price incorporates all of the available information, there’s no reason for it to change unless there’s new information .

But, well, that’s constantly happening. It’s called news.

We are constantly bombarded with new information. Both new factual information, but also how that new information makes us feel, and what that new information means for our expectations about the future. And it doesn’t even have to be new specific information that sets off this process. It could just be our interpretation of something that we already knew changes. Given how fast the world changes the question isn’t why the markets move, but rather why they don’t move even more.

There’s a catch here though – since prices incorporate expectations about the future, it’s not just whether something good or bad happens that determines if a security goes up or down. It’s how that new information squares with what the market expected to happen . If something good happened, but it wasn’t quite as good as everyone expected it to be, the price will drop. On the other hand, if something bad happened, but it wasn’t quite as disastrous as expected, the price will go up.

And this is really common to see. Just look at what happens when companies release their earnings. They are always accompanied by some sort of analyst’s estimate of what the earnings were expected to be. This is both to give us some sort of scale, but also so we can tell how the company did relative to expectations – whether the stock price should go up or down.

This means that to reliably beat the market you either need to have access to information that others don’t (which is insider trading, and I think that’s the SEC on the phone for you), or you need to be able to need to not just be able to predict the future, you need to be able to do it better than everyone else.

All Interesting Models Are Wrong

The EMH is either incredibly elegant or messy depending on your perspective. But it’s important to remember that it is just a model.

And every interesting model is wrong .

They don’t perfectly describe reality – if they did, they would be reality, and they would be so complex that they would cease to be useful. There are constantly people picking at the edges of the efficient market hypothesis trying to find ways of reliably beating the markets (such as, well, most of the finance industry and a pretty big chink of the academic finance world as well).

We can also point to specific managers, like Peter Lynch, who was either astronomically lucky, or he truly was able to beat the market. You can slice and dice his numbers any way you would like, but he clearly was adding value for his investors (though even he couldn’t pick successors who could beat the market – which is a lot more like the challenge you and I face trying to beat the market).

There are probably a huge number of market inefficiencies out there (though not every price discrepancy is an inefficiency ). But we mentioned that the market is self correcting – when investors find something out there that let’s them make money, they will pile in – to the point they can’t make any more money.

By exploiting the market inefficiency they make the market more efficient. But to prove the Efficient Market Hypothesis wrong, or even to start poking holes in it, you need to be able to find a way to beat the market that isn’t self correcting – or at least a way to find ways to beat the market.

And that hasn’t shown up yet.

How Should You Invest?

So where does this leave us? And more specifically, what does the market being efficient mean for how you should be investing for retirement?

Well, the simple answer is that you shouldn’t be trying to beat the market. You should let the market work for you.

This means keeping things simple. Start with the market portfolio (and adjust based on how you’re different from the average investor ), and use index funds . If you can’t beat the market, you might as well get the market.

But more importantly, build your portfolio as part of your broader retirement income plan. For most of us, our investment portfolio will play a big part in how we pay for retirement. But it’s not the whole plan. And you need to make sure that your investments mesh with the other pieces to create a plan that works for our retirement income style and situation.

Investing – and retirement planning – is about the long term . Markets tend to go up – that’s why we invest. But they also go down. And we need to build our portfolios to be able to deal with those drops. A well designed portfolio, in a well designed retirement plan, will let you ignore all of the short term noise and focus on enjoying the retirement you deserve.

To find out more about how to build an investment portfolio that works for you, read our eBook 9 Principles of Intelligent Investors .

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Semi-Strong Form

Strong form, the bottom line.

• Trading Strategies

The Weak, Strong, and Semi-Strong Efficient Market Hypotheses

Learn about the three versions of the efficient market hypothesis

J.B. Maverick is an active trader, commodity futures broker, and stock market analyst 17+ years of experience, in addition to 10+ years of experience as a finance writer and book editor.

The efficient market hypothesis (EMH), as a whole, theorizes that the market is generally efficient, but the theory is offered in three different versions: weak, semi-strong, and strong.

The basic efficient market hypothesis posits that the market cannot be beaten because it incorporates all important determining information into current share prices . Therefore, stocks trade at the fairest value, meaning that they can't be purchased undervalued or sold overvalued .

The theory determines that the only opportunity investors have to gain higher returns on their investments is through purely speculative investments that pose a substantial risk.

Key Takeaways

• The efficient market hypothesis posits that the market cannot be beaten because it incorporates all important information into current share prices, so stocks trade at the fairest value.
• Though the efficient market hypothesis theorizes the market is generally efficient, the theory is offered in three different versions: weak, semi-strong, and strong.
• The weak form suggests today’s stock prices reflect all the data of past prices and that no form of technical analysis can aid investors.
• The semi-strong form submits that because public information is part of a stock's current price, investors cannot utilize either technical or fundamental analysis, though information not available to the public can help investors.
• The strong form version states that all information, public and not public, is completely accounted for in current stock prices, and no type of information can give an investor an advantage on the market.

The three versions of the efficient market hypothesis are varying degrees of the same basic theory. The weak form suggests that today’s stock prices reflect all the data of past prices and that no form of technical analysis can be effectively utilized to aid investors in making trading decisions.

Advocates for the weak form efficiency theory believe that if the fundamental analysis is used, undervalued and overvalued stocks can be determined, and investors can research companies' financial statements to increase their chances of making higher-than-market-average profits.

The semi-strong form efficiency theory follows the belief that because all information that is public is used in the calculation of a stock's current price , investors cannot utilize either technical or fundamental analysis to gain higher returns in the market.

Those who subscribe to this version of the theory believe that only information that is not readily available to the public can help investors boost their returns to a performance level above that of the general market.

The strong form version of the efficient market hypothesis states that all information—both the information available to the public and any information not publicly known—is completely accounted for in current stock prices, and there is no type of information that can give an investor an advantage on the market.

Advocates for this degree of the theory suggest that investors cannot make returns on investments that exceed normal market returns, regardless of information retrieved or research conducted.

There are anomalies that the efficient market theory cannot explain and that may even flatly contradict the theory. For example, the price/earnings  (P/E) ratio shows that firms trading at lower P/E multiples are often responsible for generating higher returns.

The neglected firm effect suggests that companies that are not covered extensively by market analysts are sometimes priced incorrectly in relation to their true value and offer investors the opportunity to pick stocks with hidden potential. The January effect shows historical evidence that stock prices—especially smaller cap stocks—tend to experience an upsurge in January.

Though the efficient market hypothesis is an important pillar of modern financial theories and has a large backing, primarily in the academic community, it also has a large number of critics. The theory remains controversial, and investors continue attempting to outperform market averages with their stock selections.

Due to the empirical presence of market anomalies and information asymmetries, many practitioners do not believe that the efficient markets hypothesis holds in reality, except, perhaps, in the weak form.

What Is the Importance of the Efficient Market Hypothesis?

The efficient market hypothesis (EMH) is important because it implies that free markets are able to optimally allocate and distribute goods, services, capital, or labor (depending on what the market is for), without the need for central planning, oversight, or government authority. The EMH suggests that prices reflect all available information and represent an equilibrium between supply (sellers/producers) and demand (buyers/consumers). One important implication is that it is impossible to "beat the market" since there are no abnormal profit opportunities in an efficient market.

What Are the 3 Forms of Market Efficiency?

The EMH has three forms. The strong form assumes that all past and current information in a market, whether public or private, is accounted for in prices. The semi-strong form assumes that only publicly-available information is incorporated into prices, but privately-held information may not be. The weak form concedes that markets tend to be efficient but anomalies can and do occur, which can be exploited (which tends to remove the anomaly, restoring efficiency via arbitrage ). In reality, only the weak form is thought to exist in most markets, if any.

How Would You Know If the Market Is Semi-Strong Form Efficient?

To test the semi-strong version of the EMH, one can see if a stock's price gaps up or down when previously private news is released. For instance, a proposed merger or dismal earnings announcement would be known by insiders but not the public. Therefore, this information is not correctly priced into the shares until it is made available. At that point, the stock may jump or slump, depending on the nature of the news, as investors and traders incorporate this new information.

The efficient market hypothesis exists in degrees, but each degree argues that financial markets are already too efficient for investors to consistently beat them. The idea is that the volume of activity within markets is so high that the value of resulting prices are as fair as can be. The weak form of the theory is the most lenient and concedes that there are circumstance when fundamental analysis can help investors find value. The strong form of the theory is the least lenient in this regard, while the semi-strong form of the theory holds a middle ground between the two.

Burton Gordon Malkiel. "A Random Walk Down Wall Street: The Time-tested Strategy for Successful Investing," W.W Norton & Company, 2007.

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