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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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Efficient Market Hypothesis (EMH)

Written by True Tamplin, BSc, CEPF®

Reviewed by subject matter experts.

Updated on July 12, 2023

Are You Retirement Ready?

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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By Dheeraj Vaidya, CFA, FRM

(ex. J.P. Morgan & CLSA Equity Analyst with 20+ years of training experience)

Efficient Market Hypothesis

Last Updated :

21 Aug, 2024

Blog Author :

Wallstreetmojo Team

Edited by :

Pallabi Banerjee

Reviewed by :

Dheeraj Vaidya, CFA, FRM

Table Of Contents

What Is Efficient Market Hypothesis?

The Efficient Market Hypothesis (EMH) states that the stock asset prices indicate all relevant information very quickly and rationally. Such information is shared universally, making it impossible for investors to earn above-average returns consistently. The assumptions of this theory are criticized highly by behavioral economists or others who believe in the inherent inefficiencies of the market.

According to this hypothesis, the efficient market will not provide any profitable opportunity for trading. Thus, attaining a superior return consistently in such a condition is impossible. Time is an essential factor within which the market spreads information. This time gap provides traders the opportunity to exploit the inefficiency. Economist Eugene Fama gave the efficient market hypothesis in the 1960s.

Table of contents What Is Efficient Market Hypothesis? Assumptions Of EMH Forms Example Criticism Implication Recommended Articles

• The Efficient Market Hypothesis (EMH) states that the stock prices show all pertinent details. This information is shared globally, making it impossible for investors to gain above-average returns constantly. Behavioral economists or others who believe in the market's inherent inefficiencies criticize the theory assumptions highly. 
• In the 1960s, economist Eugene Fama provided the efficient market hypothesis.
• The Efficient Market Hypothesis (EMH) forms are weak, semi-strong, and strong.
• This theory is criticized because it has market bubbles and consistently wins against the market.

Efficient Market Hypothesis Explained

Efficient market hypothesis theory is a situation in which all assets are priced to show any new or recent information. This does not give any window to capture excess returns. However, traders who can exploit this time gap within which the market is inefficient, can earn extra returns. It can be said that trading is the way in which the new information is incorporated in the asset prices. The speed with which information is adjusted is actually the time taken foe the trade to get executed. This time frame may also be less than one minute.

Assumptions Of EMH

Let us look at some assumptions of the efficient market hypothesis theory .

• Investors in the market may act rationally or normally. If there is unusual information, the investor will react unusually, which is normal behavior, or doing what everyone else is doing is also considered normal behavior.
• The stock price indicates all the relevant information shared universally among the investors.
• It also states that the investors cannot exploit the market since they need to act as per the market information and make decisions accordingly.

Let us look at the different forms of the concept of efficient market hypothesis.

The strength of the Efficient Market Hypothesis (EMH) theory's assumptions depends upon the forms of EMH. The following are the forms of EMH: -

• Weak Form: This form states that the stock prices indicate the public market information, and the past performance has nothing to do with future costs.
• Semi-Strong Form: This form states that the stock prices reflect both the market and non-market public information.
• Strong Form: This form says that public and private information instantly characterizes stock prices.

The below given example will help in understanding the concept of efficient market hypothesis.

Suppose a person named Johnson holds 900 shares of an automobile company, and the current price of these shares trades at $156.50. Johnson had some relations with an insider of the same company who informed Johnson that the company had failed in their new project and the price of a share would decline in the next few days.

Johnson had no faith in the insider and held all his shares. Then, after a few days, the company announces the project’s failure, dropping the share price to $106.00.

The market modifies the newly available information. To realize the gross gain, Johnson sold his shares at $106.00 and a gross gain of $95,500. If Johnson had sold his 900 shares at $156.50 earlier by taking the insider's advice, he would have earned $140,850. So, his loss for the sale of 900 shares is $140,850-$95,500 i.e., $45,350.

Given below are the importance of efficient market hypothesis.

• This theory takes into account the fact that there are always some special cases or outliers who are able to use the time gap between the old pices and change in price due to new information to earn extra return.
• The importance of efficient market hypothesis also lies in the fact that it is useful in the asset pricing models.
• There is no need of government intervention since stock prices adjust automatically.

• Existence of Market Bubbles: One of the biggest reasons behind the criticism of the efficient market hypothesis is market bubbles . So, if such assumptions were correct, there was no possibility of bubbles and crashing incidents such as stock market crash and housing bubbles in 2008 or the tech bubble of the 1990s. Such companies were trading at high values before hitting. Thus, this criticism is an important argument for efficient market hypothesis testing.
• Wins against the Market: Some investors, such as Warren Buffett, won against the market consistently. He had consistently earned above-average profit from the market for over 50 years through his value investing strategy. On the other hand, some behavioral economists also highly criticize the efficient market hypothesis theory because they believe that past performances help predict future prices.

Implication

The efficient market hypothesis implies that the market is unbeatable because the stock price already contains all the relevant information. It created a conflict in the minds of the investors. They started believing they could not beat the market as it is not predictable, and future prices depend upon today’s news, not the trends or the company’s past performances. However, many economists criticized this theory. theory for the purpose of efficient market hypothesis testing.

Efficient Market Hypothesis Vs Behavioral Finance

Efficient market hypothesis states that markets are efficient since information quickly spreads whereas behavioral finance states that investors tend to be irrational in their judgement. Let us look at their differences.

Frequently Asked Questions (FAQs)

The author analyzes recent research on behavioral finance, momentum investing, and popular fundamental ratios that aims to differ from the theory and concludes that it is optional in the long run. Thus, the Efficient Market Hypothesis remains true.

The weak form Efficient Market Hypothesis, also known as the random walk theory, denotes that future securities' prices are unexpected and not affected by past events. The advocates of weak form efficiency state that all existing information is shown in stock prices. In addition, the past data has no relationship with current market prices.

The Efficient Market Hypothesis is essential because it has political implications by adhering to liberal economic thought. It suggests that no governmental intervention is required because stock prices are always traded at a 'fair' market value.

Violation of these markets suggests that markets could be more efficient. Hence, here are a few scenarios that could potentially challenge the assumptions of EMH, market anomalies, insider trading, market manipulation, behavioral biases, information asymmetry, and inefficiencies in the market microstructure

Recommended Articles

This article is a guide to what is Efficient Market Hypothesis. We explain its assumptions, forms, implications, examples, criticisms & importance. You can learn more about accounting from the following articles: -

• How to Read a Stock Chart?
• Inefficient Market
• Efficient Frontier
• Stock Market Crash in 1987

Is the Efficient Market Hypothesis True?

A widespread assumption about the stock market is that it's efficient. But is that strictly true?

Getty Images

The Efficient Market Hypothesis, or EMH, states that stock prices reflect all available information at any given time, making it impossible for investors to beat the market with any consistency.

The famed efficient market hypothesis, or EMH, is widely accepted by academics and modern investors. The hypothesis states that stock prices reflect all available information at any given time, making it impossible for investors to beat the market with any consistency.

Why, then, are there myriad examples of excess returns that should not exist if the EMH is true? To name three examples of results that seem to counter the theory: Returns vary widely across different days of the week, premarket and after-hours trading periods display mysterious return profiles, and even weather patterns strongly correlate with up and down days on Wall Street.

Here's a look at the evidence of enduring inefficiencies in the stock market that seem to fly in the face of the vaunted efficient market hypothesis, and how everyday investors can better understand the theory:

• Large gains in after-hours trading.
• Sunny-day surges.
• TGIF on Wall Street.
• The consistent outperformance of gurus.
• What meme stocks say about the efficient market hypothesis.
• Implications of the efficient market hypothesis's shortcomings.

Large Gains in After-hours Trading

Given that the stock market generally goes up over long periods as the economy grows and companies become more profitable, it's perfectly natural to expect that stocks would, on an average day, close at levels higher than where they opened.

But no. Astonishingly, stocks tend to lose ground during the trading day, which runs from 9:30 a.m. to 4 p.m. Eastern time. The magic tends to happen outside normal trading hours.

Examining returns for the popular SPDR S&P 500 ETF (ticker: SPY ), Bespoke Investment Group found that since 1993, buying at the market close and selling at the market open the next day would have returned 850%. Buying at the open and selling at the close would net you a 10% loss over the same period.

But why? Theories abound.

"This, to me, is a liquidity issue," says David Yu, a professor of practice in finance at New York University Shanghai.

"At that point, there's no liquidity, there's no trading – or very little, because it's after the markets close," Yu says. After all, it's unconventional to engage in after-hours or premarket trading, and retail investors might not know it exists or have access to it.

To Yu, it may also be an information-gap issue. "Maybe someone's heard something, and it hasn't been broadly disseminated because it's the middle of the night – everyone's asleep," Yu says.

For others, the broad discrepancy in returns isn't a mystery at all – and actually enforces the efficient market hypothesis.

"Announcements come out at 4 p.m. Company results are more often good than bad. That is an argument for the EMH – that it's bid up right at 4 p.m., when announcements come out," says Brian Huckstep, chief investment officer of Advyzon Investment Management.

In other words, markets instantly incorporate new information like earnings announcements as they come out. On the other hand, why should return discrepancies between the day and night be so dramatic, predictable and exploitable? There should not be, the EMH tells us, easily copied market-beating strategies that work – especially over long periods.

Sunny-Day Surges

A 2003 study published in the Journal of Finance pointed to another stock market quirk. The study examined "the relationship between morning sunshine in the city of a country's leading stock exchange and daily market index returns" in 26 countries between 1982 and 1997. "Sunshine is strongly significantly correlated with stock returns," it reads, noting that sunny weather is associated with positive moods.

Authors David Hirshleifer and Tyler Shumway note that using weather-based strategies was "optimal for a trader with very low transaction costs" but that frequent trading and the associated costs would likely eliminate the gains. The abstract concludes with a dryly humorous understatement: "These findings are difficult to reconcile with fully rational price setting."

While the data are a bit old in 2022, the conclusion is inescapable: For at least a 15-year period, the valuation of companies all across the world benefited when weather was good and, presumably, traders were in better moods.

Moreover, the benefit of using weather-based strategies may have been outweighed by trading costs in 2003, but virtually all mainstream brokers now have commission-free trades , making such strategies far more feasible in the 2020s.

TGIF on Wall Street

This theme of returns being predictably lopsided during certain periods continues in what is sometimes called the "weekend effect" in the stock market. One would expect the value of companies to be entirely independent of which day of the week it is, but in fact, Mondays are significantly worse for returns than Fridays.

The phenomenon goes all the way back to 1953, the first year the market was always closed on Saturdays. A 1973 research paper showed that between 1953 and 1970, the S&P 500 rose 62% of the time on Fridays and a miserable 39.5% of the time on Mondays.

Fast forwarding to 2018, and this discrepancy was still happening: That year, Fridays were the best day of the week for the S&P 500, returning an average of 0.14%. Mondays saw declines of 0.02%.

Huckstep, again, is unfazed. "It's because people spend money on the weekend," he says.

"I was an advisor for two years. You get most of your calls from people taking money out on Monday. So people sell on Monday because they spend the money on Saturday and Sunday," Huckstep says.

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The Consistent Outperformance of Gurus

"The only one I have more difficulty with is people like [Warren] Buffett who, year-in, year-out, do beat the market," Huckstep says. "So I would suggest there are certain people with a really, really high IQ who are potentially able to identify some winning ideas."

Buffett is certainly the most prominent individual example of someone who's been able to fly in the face of the EMH for decades on end. With Buffett at the helm, financial holding company Berkshire Hathaway Inc. ( BRK.A , BRK.B ) has trounced the market. From 1964 to 2021, Berkshire shares returned 3,641,613%. The S&P 500 returned 30,209% over the same period.

An arguably more remarkable market walloping has been dealt out by Renaissance Technologies' Medallion fund. The quantitative hedge fund, which employs high-frequency strategies and reportedly uses a vast trove of historical data – including variables such as weather – boasted an average annual return before fees of 66.07% between 1988 and 2018.

The fund is no longer open to outside investors – only employees at Renaissance can participate in the fund, which has performed like a money-printing machine.

"If you really, truly believed in the efficient market hypothesis, there would be no hedge funds or no single stock picker outperforming the markets, but that's obviously not true," Yu says.

What Meme Stocks Say About the Efficient Market Hypothesis

A further example of what might be considered a chink in the EMH's armor arises from the very recent phenomenon of so-called meme stocks – companies whose share prices are sometimes driven by swarms of retail investors. Mostly short-term oriented, these investor groups often target stocks with high short interest in order to trigger a " short squeeze " that is supposed to teach a lesson to demonized hedge funds that are betting against the stock.

These meme stock rallies are prime examples of the EMH's shortcomings, says Siddharth Singhai, chief investment officer of Ironhold Capital, a value-based hedge fund. One need look no further than the price activity of Bed Bath & Beyond Inc. ( BBBY ) in recent months to find issues with the theory, Singhai says. "It’s a dying retailer with no profitability and no substantial asset value."

Despite that, shares rallied from less than $5 to $23 per share, then plunged back to the $6 range, all within a few months, as retail investor hysteria catalyzed wild swings in the stock price.

Over this time, "there was no substantial change in the fundamental value of the business," Singhai notes.

More amusing examples of glaring human error in recent years also cast doubt on the narrative of rigorous efficiency in markets. During the onset of the pandemic in the early days of 2020, shares of China's Zoom Technologies Inc. (ZOOM) more than doubled in a few days. Traders had mistaken it for Zoom Video Communications Inc. ( ZM ), the rapidly growing video-conferencing software that went into hypergrowth mode with the rapid onset of the work-from-home economy.

Implications of the Efficient Market Hypothesis's Shortcomings

As many examples as there are of return dynamics that ostensibly shouldn't exist if the efficient market hypothesis is true, taking advantage of these as an average investor is another story.

Most of the aforementioned market anomalies would require trading in and out of the market on extremely short time frames, requiring an enormous level of discipline and large amounts of time. In addition, gains from such trades would incur the far more onerous short-term capital gains tax and frequently run afoul of the wash-sale rule , which states that investments sold at a loss and repurchased within 30 days can't be written off for tax purposes.

For Yu, he's a broad believer in the EMH, but with some qualifiers. "It's really for liquid markets," Yu says, and in particular the U.S. stock market, which is the most liquid and highly analyzed. Going further, Yu says the EMH is best understood as a long-term rule . "If it's one minute, of course you could outperform if you got lucky," Yu says. "From my perspective, there's sort of a reversion to the mean [toward efficient markets] over long periods of time."

For most individual investors, attempting to seize on the exceptions to the EMH, at least when it comes to U.S. stocks, is often more trouble than it's worth. On the reward-to-effort scale, few methods compare to buying low-cost index funds and sitting on your hands over the long run.

More sophisticated investors might look to take advantage of weaknesses in the efficient market hypothesis by trading micro-caps or foreign markets , which tend to be less liquid and have less analyst coverage and more information asymmetry between buyers and sellers. Of course, these strategies also carry higher risk. Other asset classes altogether – real estate, for example – arguably offer more opportunities for folks seeking to exploit inefficiencies.

Stocks Buffett Just Bought and Sold

Tags: investing , stock market , SPDRs , Berkshire Hathaway , Bed Bath & Beyond , Zoom Video Communications , Warren Buffett , hedge funds , index funds , financial literacy

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Efficient Market Hypothesis (EMH): What is It and Why Does It Matter?

What is Efficient Market Hypothesis (EMH)?

The efficient market hypothesis (EMH) is a theory in financial economics that states that the prices of assets, such as stocks, bonds, or commodities, reflect all the available information about their value. This means that investors cannot consistently beat the market by using any strategy, such as fundamental analysis, technical analysis, or insider trading. The only way to achieve higher returns is by taking more risk.

The EMH has important implications for investors, traders, and financial professionals. It suggests that the best way to invest is to buy and hold a diversified portfolio of low-cost index funds that track the market performance. This is a pillar strategy embraced by many on their financial independence journey. It also implies that financial markets are rational and efficient, and that price movements are unpredictable and random.

However, the EMH is also highly controversial and widely debated. Many critics argue that the EMH is based on unrealistic assumptions about human behavior, market structure, and information quality. They point to various anomalies and inefficiencies in the market, such as bubbles, crashes, momentum, value effects, and behavioral biases. They also cite examples of successful investors who have consistently outperformed the market over long periods of time, such as Warren Buffett, George Soros, or Peter Lynch.

In this article, we will explain the main concepts and assumptions of the EMH, the different forms and tests of market efficiency, the main arguments for and against the EMH, and the practical implications of the EMH for investors and financial professionals.

Key Takeaways

The main concepts and assumptions of the efficient market hypothesis (emh).

The EMH is based on the idea that the market is a  collective  and  efficient  mechanism that processes all the available information about the value of assets and incorporates it into their prices. Therefore, the market price of an asset is the best estimate of its  true  or  intrinsic  value, and any deviation from it is random and temporary.

The Efficient Market Hypothesis relies on several assumptions about the market participants, the market structure, and the information quality. Some of the main assumptions are:

• Rationality : Investors are rational and act in their own self-interest. They have consistent preferences and expectations, and they update them based on new information. They seek to maximize their expected utility and minimize their risk.
• Independence : Investors are independent and do not influence each other’s decisions. They have diverse opinions and beliefs, and they do not follow trends or fads. They do not suffer from any behavioral biases or irrational emotions.
• Competition : Investors are numerous and have equal access to the market. They have similar information and analytical skills, and they can trade without any barriers or costs.
• Information Quality : Information is publicly available, accurate, and timely. Investors have access to the same information and can process it efficiently. There is no asymmetric information or insider trading in the market.
• No Transaction Costs : Investors can trade without any friction or costs. There are no taxes, fees, commissions, or bid-ask spreads in the market. There are also no liquidity or short-selling constraints.

These assumptions are necessary for the EMH to hold, but they are also very idealistic and unrealistic. In reality, many of these assumptions are violated or relaxed in the real world, which creates opportunities for market inefficiencies and anomalies.

The Different Forms and Tests of Market Efficiency

The EMH has three forms: weak, semi-strong, and strong. Each form implies a different level of market efficiency and testability.

The weak form of the EMH states that asset prices reflect all the  past  information, such as historical prices and returns. This means that investors cannot use technical analysis, which relies on patterns and trends in past prices, to predict future prices or beat the market.

The weak form of the EMH can be tested by using statistical methods, such as serial correlation tests, runs tests, or filter tests, to check if past prices have any predictive power for future prices.

Semi-Strong Form

The semi-strong form of the EMH states that asset prices reflect all the publicly available information, such as financial statements, news reports, analyst recommendations, or macroeconomic indicators. This means that investors cannot use fundamental analysis, which relies on evaluating the intrinsic value of assets based on public information, to predict future prices or beat the market.

The semi-strong form of the EMH can be tested by using event studies, which examine how asset prices react to new information or events, such as earnings announcements, dividend changes, mergers and acquisitions, or regulatory changes.

Strong Form

The strong form of the EMH states that asset prices reflect all the  private  information, such as insider information or proprietary research. This means that investors cannot use any information, even if it is not publicly available, to predict future prices or beat the market.

The strong form of the EMH can be tested by using performance studies, which compare the returns of different groups of investors, such as insiders, managers, analysts, or professional traders, to see if they have any informational advantage over other investors.

The three forms of the EMH are nested within each other: if the strong form holds, then the semi-strong and weak forms must also hold; if the semi-strong form holds, then the weak form must also hold; but if the weak form holds, it does not imply that the semi-strong or strong forms hold. Therefore, the stronger the form of the EMH, the more efficient and unexploitable the market is.

The Main Arguments For and Against the Efficient Market Hypothesis (EMH)

The EMH is one of the most influential and debated theories in financial economics. There are many arguments for and against the EMH, both theoretical and empirical. Here are some of the main ones:

Arguments For the Efficient Market Hypothesis

• Empirical Evidence : There is a large body of empirical evidence that supports the EMH, especially the weak and semi-strong forms. Many studies have shown that technical analysis does not generate consistent excess returns, and that fundamental analysis does not provide reliable signals for market timing or stock selection. Moreover, many studies have shown that most active managers, who claim to have superior skills or information, fail to beat the market or their benchmarks, especially after accounting for fees, taxes, and risk.
• Theoretical Plausibility : The EMH is based on the idea that markets are efficient and rational, which is consistent with the assumptions of classical and neoclassical economics. The EMH also relies on the law of large numbers, which states that as the number of independent observations increases, the average of the observations converges to the true mean. Therefore, as more investors participate in the market, their collective actions and opinions tend to cancel out each other’s errors and biases, and the market price converges to the true value.
• Practical Implications : The EMH has practical implications for investors and financial professionals. It supports the passive investing strategy of buying and holding low-cost index funds that track the market performance. This strategy is simple, cost-effective, tax-efficient, and risk-adjusted. It also challenges the role of active managers, analysts, and regulators in the market. It suggests that they do not add any value or efficiency to the market, and that they may even create distortions or inefficiencies.

Arguments Against the Efficient Market Hypothesis

• Empirical Anomalies : There is also a large body of empirical evidence that challenges the EMH, especially the semi-strong and strong forms. Many studies have identified various anomalies and inefficiencies in the market, such as bubbles, crashes, momentum, value effects, size effects, calendar effects, dividend effects, earnings surprises, and arbitrage opportunities. These anomalies suggest that asset prices do not always reflect all available information, and that investors can exploit these inefficiencies to generate excess returns.
• Theoretical Criticisms : The EMH is also criticized for being based on unrealistic assumptions about human behavior, market structure, and information quality. Many critics argue that investors are not rational and independent, but rather irrational and influenced by each other. They suffer from various behavioral biases and irrational emotions, such as overconfidence, loss aversion, anchoring, herding, or confirmation bias. They also argue that markets are not competitive and efficient, but rather imperfect and distorted. There are various barriers and costs to trading, such as taxes, fees, commissions, bid-ask spreads, liquidity constraints, or short-selling restrictions. There are also various sources of asymmetric information or insider trading in the market, such as managers, analysts, or regulators. They also argue that information is not publicly available, accurate, or timely, but rather scarce, noisy, or manipulated. There are various sources of information noise or manipulation in the market, such as rumors, frauds, or media.
• Practical Examples : The EMH is also challenged by many practical examples of successful investors who have consistently outperformed the market over long periods of time, such as Warren Buffett, George Soros, or Peter Lynch. These investors claim to have superior skills or information that allow them to identify undervalued or overvalued assets and exploit market inefficiencies. They also use various strategies that contradict the EMH, such as value investing, growth investing, contrarian investing, or arbitrage investing.

The Practical Implications of the Efficient Market Hypothesis (EMH) for Investors and Financial Professionals

The EMH has practical implications for investors and financial professionals. Depending on whether they accept or reject the EMH, they may adopt different approaches to investing and financial decision making.

Implications for Investors

For investors who accept the EMH, the best way to invest is to follow a passive investing strategy of buying and holding a diversified portfolio of low-cost index funds that track the market performance. This strategy is simple, cost-effective, tax-efficient, and risk-adjusted. It also avoids the pitfalls of active investing, such as overtrading, underperforming, or paying high fees.

One example of a passive investing strategy that supports the EMH is the  VTSAX and Chill  strategy, which involves investing all your money in a single index fund that tracks the total US stock market: the Vanguard Total Stock Market Index Fund (VTSAX). This fund has low fees (0.04%), high diversification (over 3,600 stocks), and high returns (10.7% annualized since inception). By investing in VTSAX and chilling (i.e., not worrying about market fluctuations or timing), you can achieve financial independence in the long run.

For investors who reject the EMH, the best way to invest is to follow an active investing strategy of using various methods and techniques to identify undervalued or overvalued assets and exploit market inefficiencies. This strategy is complex, costly, tax-inefficient, and riskier. It also requires the skills, information, and discipline of active investing, such as research, analysis, forecasting, timing, or trading.

One example of an active investing strategy that challenges the EMH is the  value investing  strategy, which involves buying stocks that are trading below their intrinsic value and selling them when they reach their fair value. This strategy is based on the idea that the market often misprices stocks due to irrationality, noise, or manipulation, and that investors can use fundamental analysis to estimate the true value of stocks based on their earnings, assets, dividends, or growth potential. By investing in value stocks and holding them for a long time, investors can achieve superior returns.

Implications for Financial Professionals

The EMH affects how financial professionals create, manage, or advise on financial products and services. They may use different approaches depending on whether they accept or reject the EMH.

For financial professionals who accept the EMH, the best way to add value and efficiency to the market is to create and maintain low-cost index funds that track the market performance. This approach is consistent with the EMH and benefits the investors. One example of a financial professional who follows this approach is  John Bogle , the founder of Vanguard Group and the creator of the first index fund.

For financial professionals who reject the EMH, the best way to add value and efficiency to the market is to use methods and techniques to find undervalued or overvalued assets and exploit market inefficiencies. This approach is inconsistent with the EMH and benefits the investors. One example of a financial professional who follows this approach is  Warren Buffett , the chairman and CEO of Berkshire Hathaway and one of the most successful investors of all time.

The efficient market hypothesis (EMH) is a theory that states that asset prices reflect all available information and that investors cannot consistently beat the market by using any strategy. The EMH has three forms: weak, semi-strong, and strong. Each form implies a different level of market efficiency and testability.

The EMH is supported by some empirical evidence, theoretical plausibility, and practical implications. It suggests that the best way to invest is to buy and hold low-cost index funds that track the market performance. It also challenges the role of active managers, analysts, and regulators in the market.

The EMH is challenged by some empirical anomalies, theoretical criticisms, and practical examples. It suggests that the market often misprices assets due to irrationality, noise, or manipulation. It also provides opportunities for investors to exploit market inefficiencies and achieve superior returns.

The EMH is one of the most influential and debated theories in financial economics. It has shaped the way we think about markets, investing, and finance. It is not a definitive or conclusive theory, but rather a useful framework for understanding and analyzing markets. It is up to each individual to decide whether they believe in it or not, and how they apply it to their own financial goals.

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Efficient Markets Hypothesis

• Reference work entry
• First Online: 01 January 2018
• pp 3543–3560
• Cite this reference work entry

• Andrew W. Lo 1  

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The efficient markets hypothesis (EMH) maintains that market prices fully reflect all available information. Developed independently by Paul A. Samuelson and Eugene F. Fama in the 1960s, this idea has been applied extensively to theoretical models and empirical studies of financial securities prices, generating considerable controversy as well as fundamental insights into the price-discovery process. The most enduring critique comes from psychologists and behavioural economists who argue that the EMH is based on counterfactual assumptions regarding human behaviour, that is, rationality. Recent advances in evolutionary psychology and the cognitive neurosciences may be able to reconcile the EMH with behavioural anomalies.

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From standard to evolutionary finance: a literature survey

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Acknowledgment

I thank John Cox, Gene Fama, Bob Merton, and Paul Samuelson for helpful discussions.

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Lo, A.W. (2018). Efficient Markets Hypothesis. In: The New Palgrave Dictionary of Economics. Palgrave Macmillan, London. https://doi.org/10.1057/978-1-349-95189-5_42

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Efficient Market Hypothesis

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

Investopedia contributors come from a range of backgrounds, and over 25 years there have been thousands of expert writers and editors who have contributed.

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 .

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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.

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