EMH theory is a highly disputed and controversial theory in modern financial economics.
The full form of EMH theory is the Efficient Market Hypothesis. The proponents of the EMH theory believe that outsized risk-adjusted returns can be achieved only if investors rely on speculation or gather inside information.
Before learning about the efficient market hypothesis assumptions, types, and strategies, let’s check what EMH theory is.
What is efficient market hypothesis theory
EMH theory is an important modern financial theory. An economist named economist Eugene Fama was the first person to formulate it in the late 1960s.
It hypothesises that generally markets function in an efficient manner and stocks always trade at their fair values on stock exchanges. This means all available information gets reflected in stock prices.
According to this theory, fundamental analysis and technical analysis cannot provide you with higher returns. The proponents believe that no investor or trader can buy undervalued stocks or sell overvalued stocks. This is mainly because EMH theory believes that all stocks trade at their fairest value only.
According to the Efficient Market Hypothesis theory, no investor can outperform the market until and unless they have insider information. Theoretically, investors may also beat market returns if they make speculative investments, which is very risky.
Efficient Market Hypothesis theory: How does it work?
According to the EMH theory, the current prices of a stock incorporate all kinds of available information.
When new information is revealed, the prices adjust themselves quickly to accommodate it. That’s why, as per the Efficient Market Hypothesis theory, it is almost impossible for any investor to outperform the market consistently on a risk-adjusted basis.
Impact of the EMH theory
The efficient markets hypothesis suggests that all available information is already reflected in stock prices. This makes it hard to consistently outperform the market. It must be noted that this theory has made index funds very popular. For those unaware, index funds aim to match the market’s performance rather than beat it.
Several investors who believe in EMH prefer these low-cost and passive investments. While investing, they don’t expect fund managers to do much better than the overall market.
Moreover, because the EMH also shows how tough it is to outperform the market consistently, those few fund managers who can do so become highly valued. In this case, investors are willing to pay more for their expertise. This has even led to a small group of highly respected fund managers who are in high demand despite the general trend towards passive investing.
Top 5 efficient market hypothesis assumptions
There are five major assumptions in EMH theory. Let us check them closely.
- All market players have perfect information and the market is efficient
All market participants are assumed to have all kinds of information regarding a stock. The theory also assumes that information is free and that all new information is available to all market players instantly. At a certain point in time, all available information is reflected in the prices of stocks. - Investors are rational
All investors are assumed to be rational decision-makers. Their sole aim is the maximization of their utility. FOMO or others don’t affect their decision-making capabilities. They are assumed to make decisions logically to maximise their utilities. - Zero transaction cost
EMH theory assumes that a trader or investor doesn’t have to pay any transaction cost (fee and tax) for buying or selling stocks. - Frictions in the market are absent
In the real world, many market restrictions can be seen. Some of the most common restrictions are trading impediments, borrowing constraints, short selling, and many more. However, the efficient market hypothesis assumes that the market is efficient and all market players can take any position freely and without any restriction. - Prices are determined randomly
The EMH theory believes that studying stock price patterns in the past can’t be used to predict any future price movement. This is because the theory hypothesises that stock prices are determined randomly. That’s why technical analysis to predict future prices is considered futile as per the efficient market hypothesis.
What are the different types of EMH theory?
There are 3 types of efficient market hypothesis:
- Weak EHM
EMH theory assumes that all kinds of market information are reflected in stock prices accurately. However, the weak EHM theory acknowledges that prices may not always incorporate all information perfectly. It acknowledges a real-world situation where some information may not have been made public. The weak EHM theory believes that new information made available to the public influences pricing. However, WEHM believes that historical prices don’t affect current or future prices. That’s why it also considers technical analysis ineffective. - Semi-Strong EMH
According to this theory, new public information makes stock prices adjust quickly. It believes that neither fundamental nor technical analysis can provide investors with abnormally high profits. - Strong EMH
The strong efficient market hypothesis proposes that a stock price incorporates all possible information (whether public or private). It believes that investors having confidential information cannot make profit from sudden fluctuations in stock prices. This is because the market has already incorporated all relevant data.
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Is the efficient market hypothesis true
The EMH suggests that stock prices reflect all available information, and it is difficult to consistently outperform the market. However, real-world markets aren't always perfect, and whether EMH holds true depends on what evidence you consider. Below are some points in favour as well as against this theory:
In favour of efficient markets
Some studies show that predicting short-term stock prices is very challenging. This finding aligns with the idea that markets are efficient. As a result, trying to predict short-term movements doesn’t offer a reliable advantage.
Also, many professional fund managers struggle to consistently outperform market indexes. This again supports the notion that it’s tough to beat the market when prices already reflect all information.
Against efficient market
There are cases where stock prices don't seem to fully reflect all available information. Usually, this leads to the creation of “patterns” or “anomalies” that some investors can take advantage of. Also, these discrepancies create opportunities for investors to identify and profit from mispriced stocks.
Furthermore, behavioural finance, which studies how human psychology affects market decisions, suggests that emotions and biases can cause inefficiencies in the market. Additionally, financial crises, where stock prices rapidly rise or fall irrationally, strongly challenge the EMH theory.
Key takeaways
- The EMH theory suggests that stock prices already reflect all available information, and they are fairly priced.
- According to EMH, stocks are always traded at their “fair value” based on all known information. Therefore, they are neither overpriced nor underpriced.
- Supporters of EMH believe it is hard to consistently outperform the market. Hence, it is better to invest in a low-cost and passive portfolio like an index fund.
- The critics of EMH argue that it is possible to beat the market because sometimes stocks are not priced accurately, and investors can take advantage of this mispricing.
Special considerations
Several supporters of the EMH argue that the market is unpredictable, and it is difficult for investors to consistently pick winning stocks. Instead, they suggest that investing in low-cost and passive portfolios like index funds or ETFs is a better strategy. That’s because these funds try to match the market’s overall performance rather than trying to outperform it. These funds better align with the idea that the market efficiently prices all available information.
Now, if we talk about a study (Active/ Passive Barometer) conducted by Morningstar in June 2019, it supports this view. The study compared the performance of active managers who try to outperform the market and are against passive index funds and ETFs. Over ten years, from June 2009 to June 2019, only 23% of active managers outperformed their passive counterparts.
Moreover, the study found better success rates for active managers in “foreign equity” and “bond funds” but lower success rates in U.S. large-cap funds. This suggests that, overall, passive investing delivers better results for most investors.
Furthermore, it is worth mentioning that even though some active managers do outperform passive funds at times, identifying these managers is challenging. The study also highlights that less than 25% of top-performing active managers can maintain their superior performance over time.
Again, this statistic clearly shows the difficulty of beating the market and supports the idea that most investors would fare better by sticking with passive investment strategies rather than trying to pick the few active managers who might succeed.
Final words
The proponents of the efficient market hypothesis (EHM) theory say that in the long run, most investors will get a return that is similar to the market performance. However, detractors say that the EHM proponents don’t consider the active investing scenario where investors can continuously include better-performing stocks in their portfolio to outperform the market. Most proponents of EHM theory suggest investors buy and hold stocks for the long term to gain profit, which is the same return as the market.
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