Efficient Markets Hypothesis (EMH)

 

Efficient Markets Hypothesis (EMH)

 

Introduction

The Efficient Markets Hypothesis (EMH) is an investment theory.

By Eugene Fama’s research as detailed in his 1970 book, “Efficient Capital Markets: A Review of Theory and Empirical Work.”

Fama put forth the basic idea that it is virtually impossible to consistently “beat the market” – to make investment returns that outperform the overall market average as reflected by major stock indexes such as the S&P 500 Index.

 

Assumptions of the Efficient Markets Hypothesis

—  The assumptions include the one idea critical to the validity of the efficient markets hypothesis: the belief that all information relevant to stock prices is freely and widely available, “universally shared” among all investors.

—  As there are always a large number of both buyers and sellers in the market, price movements always occur efficiently (i.e., in a timely, up-to-date manner). Thus, stocks are always trading at their current fair market value.

—  The major conclusion of the theory is that since stocks always trade at their fair market value, then it is virtually impossible to either buy undervalued stocks at a bargain or sell overvalued stocks for extra profits. Neither expert stock analysis nor carefully implemented market timing strategies can hope to average doing any better than the performance of the overall market.

 

Variations of the Efficient Markets Hypothesis

—  There are three variations of the hypothesis – the weak, semi-strong, and strong forms – which represent three different assumed levels of market efficiency.

—  The weak form suggests today’s stock prices reflect all the data of past prices and that no form of technical analysis can aid investors. 

—  The semi-strong form submits that because public information is part of a stock's current price, investors cannot utilize either technical or fundamental analysis, though information not available to the public can help investors.

—  The strong form version states that all information, public and not public, is completely accounted for in current stock prices, and no type of information can give an investor an advantage on the market.