What is the Efficient Market Hypothesis (EMH)?

The efficient market hypothesis is like the porridge in Goldilocks and the Three Bears…

When Goldilocks tries one bowl of porridge, it’s too hot. The second bowl is too cold. But the third is just right. According to the efficient market hypothesis, the market is always like the third bowl of porridge. Stocks can’t have prices that are too high or too low. Instead, the prices are always just right.

The efficient market hypothesis is a theory first proposed in the 1960s by economist Eugene Fama. The theory argues that in a liquid market (meaning one in which people can easily buy and sell), the price of a security accounts for all available information. In essence, the market price of a share is always the correct price (as if guided by an invisible hand). No investor can buy stocks below the fair market value or sell stocks for more than the fair market value.

Because the market price always accounts for all available information, the theory argues that no investor can outperform the market based on picking stocks skillfully. Instead, the only way to increase returns is by purchasing riskier securities, which should offer greater returns due to their risk premium.

However, there is a lot of debate about the accuracy of the efficient market hypothesis. Critics of the hypothesis, including well-known investor Warren Buffett, argue that people often buy stocks based on their emotions or greed rather than any rational thought about their value.

Proponents of the theory argue that prices tend to fall near their true fair market value. And even when prices don’t reflect fair value, investors still wouldn’t have an opportunity to increase their risk-adjusted returns (also called alpha). Thus, proponents say this supports the theory’s contention that investors can’t earn greater returns by buying undervalued stocks and selling overvalued ones.

The efficient market hypothesis has three forms, each accounting for varying availability of public and private information.

The weak form of the efficient market hypothesis argues that technical analysis (the study of chart patterns and trends in the number of buy and sell orders) can’t help an investor increase their risk-adjusted returns. According to this form of the theory, things like trade volume and historical prices would have no impact on the future price of a stock.

The semi-strong form of the efficient market hypothesis argues that fundamental analysis (studying the underlying business’s financial statements, opportunities, and performance) can’t help an investor earn higher risk-adjusted returns.

This form of the efficient market hypothesis states that share prices adjust to newly available public information very quickly, and that prices account for all available public information.

Belief in the semi-strong efficient market hypothesis includes the belief in the weak efficient market hypothesis, so proponents of this idea believe that neither technical nor fundamental analysis can help investors increase returns.

The strong efficient market hypothesis argues that stock prices account for all available information, whether it’s public or private. This means that even people trading with insider knowledge (which is illegal) can’t earn more than other investors without buying higher-risk investments.

This form of the efficient market hypothesis relies on the assumption that nobody has a monopoly on relevant information. If one person knows something about a company, even if it’s private information, then enough other people must know about it for the stock price to reflect that information.

Proponents of the strong efficient market hypothesis believe that there’s no way for any investor to earn higher risk-adjusted returns than others on a consistent basis.

One assumption of the efficient market hypothesis is that all investors see and analyze information in the same way. In other words, any two people would draw the same conclusions when presented with the same data. In reality, this isn’t always the case, and many investors look for different pieces of information when making investing decisions.

Another assumption of the efficient market hypothesis is that investors act rationally. If investors act irrationally, emotions such as fear or greed could cause them to purchase stocks for more than their true value or sell them for less. According to the efficient market hypothesis, this wouldn’t happen.

A third assumption is that relevant information travels almost instantly, and that all investors have access to the same information as everyone else. If information didn’t travel quickly enough for all investors to know it, those with advanced knowledge could buy or sell shares for something other than their fair value.

The efficient market hypothesis is important because it describes a theory about the valuation of shares and investors’ ability to earn money on their investments. Specifically, it argues that investors couldn’t consistently earn a higher return on investment (ROI) than other investors without accepting a higher level of risk.

Many investors who believe in the efficient market hypothesis incorporate it in their investment strategy. Those who agree that the only way to increase returns is to increase risk in their portfolio tend to practice buy and hold investing more than active trading. This has led some investors to focus on strategies that aim to track the market rather than beat it. One such strategy is indexing, which has grown popular in recent times.

The efficient market hypothesis has also encouraged investors to consider the effect of risk on portfolio performance. According to the hypothesis, the best way to improve performance is to take on more systemic risk, purchasing additional shares in higher-risk companies while maintaining a diverse portfolio.

The efficient market hypothesis has also played a role in strengthening rules against insider trading. The rules have expanded to include anyone who has privileged information, even if they aren’t connected to the companies involved. Regulators have sought to maintain market efficiency, and people with private information make the market less efficient.

One advantage of the efficient market hypothesis is that it explains how the market sets the value of different stocks. It also describes one of the most impactful ways for investors to increase their portfolio return: taking on additional risk. Just bear in mind that not everyone can accept this increased risk.

Another advantage of the hypothesis, assuming it’s true, is that both new and experienced investors have the same opportunities in the market. Because fundamental and technical analysis can’t help investors find lucrative buying or selling opportunities, all investors have the same ability to make money, even if they don’t have personal access to market data or research. The market price for a share includes all of that information, even if an individual investor can’t access it.

One limitation of the efficient market hypothesis is that it fails to explain bubbles or high levels of volatility in the market. For example, the efficient market hypothesis fails to explain the 2008 financial crisis. One of the potential causes of the crisis was irrational investors continuing to put money into low-quality mortgage securities, creating a bubble in the real estate market. If the market were truly efficient, then no bubble could occur because prices would automatically adjust.

Another limitation is that the hypothesis assumes that all investors have access to the same information at the same time and process it in the same way. In reality, some investors have more time to read market news and analysis. Some have different sources of information, such as subscriptions to newspapers and websites that track the market. Even someone with access to all the relevant information on the planet doesn’t have time to read and comprehend it all.

On top of that, two people could receive the same information and process it differently. If two investors heard news of a major acquisition by a company they want to invest in, one could see it as great news while the other could view it as a bad move by the company. One investor’s analysis might be that share price should increase, while the other might think they should fall.