efficient market hypothesis example sentence

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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 Market Hypothesis (Emh)

Definition of efficient market hypothesis (emh).

The Efficient Market Hypothesis (EMH) is a financial theory stating that asset prices fully reflect all available information. According to EMH, stocks always trade at their fair value on stock exchanges, making it impossible for investors to either purchase undervalued stocks or sell stocks for inflated prices. Therefore, it suggests that it is not possible to “beat the market” through expert stock selection or market timing, and that the only way an investor can possibly achieve higher returns is by purchasing riskier investments.

Forms of EMH

EMH is typically divided into three forms based on the degree of information considered to be reflected in asset prices:

1. Weak Form EMH: This form claims that past prices and volume information are fully reflected in stock prices and that technical analysis cannot be used to achieve superior returns.

2. Semi-strong Form EMH: Argues that all publicly available information is fully reflected in stock prices, not just past prices. According to this form, neither fundamental nor technical analysis can provide investors with an edge.

3. Strong Form EMH: The strongest version asserts that all information, public and private (insider knowledge), is fully incorporated into stock prices. Therefore, no one can have an advantage in the market.

Consider an investor analyzing Company XYZ’s stock, which is currently priced at $100 per share. According to EMH, this price takes into account all available information—including past trading data, recent financial reports, and even upcoming product launches known to the public. If new information is revealed (e.g., a breakthrough product is launched), the market will quickly adjust, and the stock price will immediately reflect this new information.

Why Efficient Market Hypothesis Matters

The Efficient Market Hypothesis matters because it has profound implications for financial research, investment strategies, and market regulation. For investors, it challenges the notion that active trading and complex investment strategies can consistently outperform the broader market. This has led to a rise in passive investment strategies, such as index fund investing, which aim to match market returns rather than beat them.

EMH also influences regulatory policies regarding market transparency and fairness, underpinning the belief that equal access to information among all market participants is crucial for market efficiency.

Frequently Asked Questions (FAQ)

Can anomalies exist within an efficient market.

Yes, market anomalies can and do occur within the framework of EMH. These anomalies are seemingly inexplicable patterns or occurrences in the market that could provide opportunities for superior returns. Examples include the small-cap effect or the January effect. However, proponents of EMH argue that these anomalies are either quickly corrected by the market or explained by higher risk.

How do behavioral economics challenge the EMH?

Behavioral economics introduces psychological insights into economic behavior, challenging the EMH by suggesting that cognitive biases and irrational decision-making can lead to mispricings in the market. For instance, overconfidence or herd behavior can cause prices to deviate from their true value, suggesting that markets are not always perfectly efficient.

Is it still worthwhile to conduct financial analysis if markets are efficient?

Even in an efficient market, financial analysis is valuable for understanding the intrinsic value of assets, managing risk, and forming a basis for investment according to an investor’s risk tolerance and investment goals. Additionally, while EMH suggests markets are generally efficient, discrepancies and opportunities may still arise, particularly in less observed or more complex markets.

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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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What Is Market Efficiency?

Market efficiency explained, differing beliefs of an efficient market, an example of an efficient market.

• Fundamental Analysis

Market Efficiency Explained: Differing Opinions and Examples

Investopedia / Daniel Fishel

Market efficiency refers to the degree to which market prices reflect all available, relevant information. If markets are efficient, then all information is already incorporated into prices, and so there is no way to "beat" the market because there are no undervalued or overvalued securities available.

The term was taken from a paper written in 1970 by economist Eugene Fama, however Fama himself acknowledges that the term is a bit misleading because no one has a clear definition of how to perfectly define or precisely measure this thing called market efficiency. Despite such limitations, the term is used in referring to what Fama is best known for, the efficient market hypothesis (EMH) .

The EMH states that an investor can't outperform the market, and that market anomalies should not exist because they will immediately be arbitraged away. Fama later won the Nobel Prize for his efforts. Investors who agree with this theory tend to buy index funds that track overall market performance and are proponents of passive portfolio management.

Key Takeaways

• Market efficiency refers to how well current prices reflect all available, relevant information about the actual value of the underlying assets.
• A truly efficient market eliminates the possibility of beating the market, because any information available to any trader is already incorporated into the market price.
• As the quality and amount of information increases, the market becomes more efficient reducing opportunities for arbitrage and above market returns.

At its core, market efficiency is the ability of markets to incorporate information that provides the maximum amount of opportunities to purchasers and sellers of securities to effect transactions without increasing transaction costs. Whether or not markets such as the U.S. stock market are efficient, or to what degree, is a heated topic of debate among academics and practitioners.

There are three degrees of market efficiency. The weak form of market efficiency is that past price movements are not useful for predicting future prices. If all available, relevant information is incorporated into current prices, then any information relevant information that can be gleaned from past prices is already incorporated into current prices. Therefore future price changes can only be the result of new information becoming available.

Based on this form of the hypothesis, such investing strategies such as momentum or any technical-analysis based rules used for trading or investing decisions should not be expected to persistently achieve above normal market returns. Within this form of the hypothesis there remains the possibility that excess returns might be possible using fundamental analysis. This point of view has been widely taught in academic finance studies for decades, though this point of view is no long held so dogmatically.

The semi-strong form of market efficiency assumes that stocks adjust quickly to absorb new public information so that an investor cannot benefit over and above the market by trading on that new information. This implies that neither technical analysis nor fundamental analysis would be reliable strategies to achieve superior returns, because any information gained through fundamental analysis will already be available and thus already incorporated into current prices. Only private information unavailable to the market at large will be useful to gain an advantage in trading, and only to those who possess the information before the rest of the market does.

The strong form of market efficiency says that market prices reflect all information both public and private, building on and incorporating the weak form and the semi-strong form. Given the assumption that stock prices reflect all information (public as well as private), no investor, including a corporate insider, would be able to profit above the average investor even if he were privy to new insider information.

Investors and academics have a wide range of viewpoints on the actual efficiency of the market, as reflected in the strong, semi-strong, and weak versions of the EMH. Believers in strong form efficiency agree with Fama and often consist of passive index investors. Practitioners of the weak version of the EMH believe active trading can generate abnormal profits through arbitrage, while semi-strong believers fall somewhere in the middle.

For example, at the other end of the spectrum from Fama and his followers are the value investors , who believe stocks can become undervalued, or priced below what they are worth. Successful value investors make their money by purchasing stocks when they are undervalued and selling them when their price rises to meet or exceed their intrinsic worth.

People who do not believe in an efficient market point to the fact that active traders exist. If there are no opportunities to earn profits that beat the market, then there should be no incentive to become an active trader. Further, the fees charged by active managers are seen as proof the EMH is not correct because it stipulates that an efficient market has low transaction costs.

While there are investors who believe in both sides of the EMH, there is real-world proof that wider dissemination of financial information affects securities prices and makes a market more efficient.

For example, the passing of the Sarbanes-Oxley Act of 2002 , which required greater financial transparency for publicly traded companies, saw a decline in equity market volatility after a company released a quarterly report. It was found that financial statements were deemed to be more credible, thus making the information more reliable and generating more confidence in the stated price of a security. There are fewer surprises, so the reactions to earnings reports are smaller. This change in volatility pattern shows that the passing of the Sarbanes-Oxley Act and its information requirements made the market more efficient. This can be considered a confirmation of the EMH in that increasing the quality and reliability of financial statements is a way of lowering transaction costs.

Other examples of efficiency arise when perceived market anomalies become widely known and then subsequently disappear. For instance, it was once the case that when a stock was added to an index such as the S&P 500 for the first time, there would be a large boost to that share's price simply because it became part of the index and not because of any new change in the company's fundamentals. This index effect anomaly became widely reported and known, and has since largely disappeared as a result. This means that as information increases, markets become more efficient and anomalies are reduced.

Fama, Eugene F. “ Efficient Capital Markets: A Review of Theory and Empirical Work .” The Journal of Finance , vol. 25, no 2, May 1970, pp. 383.

Chicago Booth Review. “ Eugene F. Fama, Efficient Markets, and the Nobel Prize .”

Fama, Eugene F. “ Efficient Capital Markets: A Review of Theory and Empirical Work .” The Journal of Finance , vol. 25, no 2, May 1970, pp. 388.

Fama, Eugene F. “ Efficient Capital Markets: A Review of Theory and Empirical Work .” The Journal of Finance , vol. 25, no 2, May 1970, pp. 404-405.

Fama, Eugene F. “ Efficient Capital Markets: A Review of Theory and Empirical Work .” The Journal of Finance , vol. 25, no 2, May 1970, pp. 409-410.

Wolla, Scott A. “ Stock Market Strategies: Are You an Active or Passive Investor? ” Federal Reserve Bank of St. Louis , April 2016, p. 3.

Chlikani, Surya, and D’Souza, Frank. “ The Impact of Sarbanes-Oxley on Market Efficiency: Evidence from Mergers and Acquisitions Activity .” The International Journal of Business and Finance Research , vol. 5, no 4, 2011, p. 75.

National Bureau of Economic Research. “ Stock Price Reactions to Index Inclusion .”

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• Efficient Market Theory

Written by True Tamplin, BSc, CEPF®

Reviewed by subject matter experts.

Updated on June 08, 2023

Get Any Financial Question Answered

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

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

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

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

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

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

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

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

Forms of Efficient Market Theory

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

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

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

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

Empirical Evidence in Support of Efficient Market Theory

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

Stock Prices Follow Random Pattern

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

Market Prices Are Unpredictable

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

Actively Managed Funds Underperform

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

Criticisms of Efficient Market Theory

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

Investors Are Not Rational

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

Reflected Market Prices Are Not Always Correct

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

Prices Are Influenced by External Factors

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

Behavioral Finance and Efficient Market Theory

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

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

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

Implications of Efficient Market Theory

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

Portfolio Management

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

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

Market Regulation

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

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

Alternatives to Efficient Market Theory

There are several alternative theories and perspectives to EMT:

Technical Analysis

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

Fundamental Analysis

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

Value Investing

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

Final Thoughts

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

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

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

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

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

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

Efficient Market Theory FAQs

What is efficient market theory.

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

What are the forms of efficient market theory?

Is there empirical evidence to support efficient market theory.

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

What are the criticisms of efficient market theory?

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

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

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

About the Author

True Tamplin, BSc, CEPF®

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

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

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

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Strategic Planning, Alternative Investments, Stock Options & Wealth Preservation

Claudia Valladares

Bilingual in english / spanish, founder of wisedollarmom.com, quoted in gobanking rates, yahoo finance & forbes.

Retirees, Immigrants & Sudden Wealth / Inheritance

Retirement Planning, Personal finance, Goals-based Planning & Community Impact

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