What is Efficient Market Hypothesis (EMH)?

Efficient Market Hypothesis (EMH)

Market efficiency refers to a condition in which current prices reflect all the publicly available information about a security. The basic idea underlying market efficiency is that competition will drive all information into the stock price quickly. Thus EMH states that it is impossible to ‘beat the market’ because stock market efficiency causes existing share prices to always incorporate and reflect all relevant information. According to the EMH, stocks always tend to trade at their fair value on stock exchanges, making it impossible for investors to either consistently purchase undervalued stocks or sell stocks at inflated prices. As such, it should be impossible to outperform the overall market through expert stock selection or market timing and that the only way an investor can possibly obtain higher returns is by purchasing riskier investments. The EMH has three versions, depending on the level on information available:

Weak form EMH

The weak form EMH stipulates that current asset prices reflect past price and volume information. The information contained in the past sequence of prices of a security is fully reflected in the current market price of that security. The weak form of the EMH implies that investors should not be able to outperform the market using something that “everybody else knows”. Yet, many financial researchers study past stock price series and trading volume (using a technique called technical analysis) data in an attempt to generate profits.

Semi-strong form EMH

The semi-strong form of the EMH states that all publicly available information is similarly already incorporated into asset prices. In other words, all publicly available information is fully reflected in a security’s current market price. Public information here includes not only past prices but also data reported in a company’s financial statements, its announcements, economic factors and others. It also implies that no one should be able to outperform the market using something that “everybody else knows”. The semi-strong form of the EMH thus indicates that a company’s financial statements are of no help in forecasting future price movements and securing high investment returns in the long-term.

Strong form EMH

The strong form of the EMH stipulates that private information or insider information too is quickly incorporated in market prices and therefore cannot be used to reap abnormal trading profits. Thus, all information, whether public or private, is fully reflected in a security’s current market price. This means no long-term gains are possible, even for the management of a company, with access to insider information. They are not able to take the advantage to profit from information such as a takeover decision which may have been made a few minutes ago. The rationale to support this is that the market anticipates in an unbiased manner, future developments and therefore information has been incorporated and evaluated into market price in a much more objective and informative way than company insiders can take advantage of.

Although it is a cornerstone of modern financial theory, the EMH is controversial and often disputed by market experts. In the years immediately following the hypothesis of market efficiency (EMH), tests of various forms of efficiency had suggested that the markets are reasonably efficient and beating them was not possible. Over time, this led to the gradual acceptance of the efficiency of markets. Academics later pointed out a number of instances of long-term deviations from the EMH in various asset markets which lead to arguments that markets are not always efficient. Behavioral economists attribute the imperfections in financial markets to a combination of cognitive biases such as overconfidence, overreaction, representative bias, information bias and various other predictable human errors in reasoning and information processing.

Other empirical studies have shown that picking low P/E stocks can increase chances of beating the markets. Speculative economic bubbles are an anomaly when it comes to market efficiency. The market often appears to be driven by buyers operating on irrational exuberance, who take little notice of underlying value. These bubbles are typically followed by an overreaction of frantic selling, allowing shrewd investors to buy stocks at bargain prices and profiting later by beating the markets. Sudden market crashes are mysterious from the perspective of efficient markets and throw market efficiency to the winds. Other examples are of investors, who have consistently beaten the market over long periods of time, which by definition should not be probable according to the EMH. Another example where EMH is purported to fail are anomalies like cheap stocks outperforming the markets in the long term.

Arguments against EMH

Alternative prescriptions about the behaviour of markets are widely discussed these days. Most of these prescriptions are based on the irrationality of the markets in, either processing the information related to an event or based on biased investor preferences. You can read about regulatory hinderances affecting stock prices here and insight of behavioural finance here.