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. Beginners’ corner:
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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. Note: According to a weak form of efficiency, analyzing historical price data doesn’t help predict future prices because if all available information is already accounted for, then any past information would be irrelevant as it is already incorporated in the price. Only any new information that becomes available can result in a price change. 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. Note: In reality, it takes some time for any newly available information to reflect in market prices, and according to the EMH, there is no definition of how much time it should take for the stock price to reflect their fair value. So the fact that EMH allows and admits random occurrences where price changes are delayed after the release of new information means an absolute market efficiency is technically impossible.
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.
