As an investor, you must have wondered whether the stock’s price has considered all the relevant information. This is because when markets are effective or consider important information, it is reflected in share prices.
When a capital market operates effectively, information is immediately and adequately reflected in security prices, allowing share prices to accurately represent predicted profits and business risks. Therefore, all current risk-based asset pricing models are built on the Efficient Market Hypothesis (EMH) foundation.
Let us understand what Efficient Market Hypothesis is.
What is an efficient market and hypothesis?
To understand the theory better, let’s break it down into two parts- efficient market and hypothesis.
In an Efficient market, all vital information is available to everybody involved in the market at the same point in time, and prices change immediately according to this information. So, for example, if all participants of BSE could predict the market value, the ABC company’s share price does not change. Then BSE can be considered an efficient market, and company ABC’s share price reflects all information about the company.
Coming on to the next part: what is a hypothesis? A hypothesis is a theory or explanation for something based on facts but has yet to be supported by evidence.
The Efficient Market Hypothesis is a theory of investing that contends that the value of financial instruments accurately reflects all available market data. Because of this, investors cannot get an edge over one another by analyzing the stocks and using various market timing strategies.
What is the Efficient Market Hypothesis?
After you have learned what each term in this theory’s name means, let’s understand the Efficient Market Hypothesis. Eugene Fama, in the 1960s, devolved this theory from the Fair Game Model and the Random Walk Theory. For the same, he has classified 3 types of market efficiency: weak form, semi-strong form, and strong form efficiency. This theory establishes a relationship between news (or information) and prices, as buyers and sellers generally have access to the same information.
According to the theory, prices of traded assets like stocks should accurately reflect all information about the market that is available to the public. For example, the company should consider its quarterly results to determine its stock price. As a result, it will be impossible to outperform the market over the long term if you invest in assets based on publicly available information because both buyers and sellers are using the same information.
Let us consider an example for simple understanding: If prices move according to public information and occur efficiently, it implies that stocks are trading at a ‘fair’ price. Since supporters of the hypothesis believe that the market is random, information cannot be predicted by the general public. Therefore, buying undervalued stocks or selling them for inflated prices will not allow investors to “beat” the market. The efficient market theory argues that it is impossible to continually outperform the market average concerning investment returns, even if you are lucky once or twice.
Types of Efficient Market Hypothesis
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Weak form of the Efficient Market Hypothesis
Stock prices reflect all past price information
A weak theory asserts that past stock prices are reflected in today’s price. Further, it states that the stock’s previous performance differs from its prospects. In this case, technical analysis cannot make money from the market.
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Semi-strong form of the Efficient Market Hypothesis
Stock prices consider all past and current publicly available information
The semi-strong version of the theory asserts that every piece of information that is made publicly available takes stock prices into account. As a result, investors cannot outperform the market and achieve significant gains using fundamental analysis. Any technical analysis and fundamental analysis would be pointless in this scenario. In semi-strong form, the market has not used future predictions. If an investor predicts future information, they can beat the market.
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Strong form of the Efficient Market Hypothesis
Stock prices consider all information that is not yet disclosed to the general public, such as confidential information
According to the theory, stock prices should consider all public and private information. Therefore, it is assumed that neither insiders nor outsiders have an advantage over one another due to the information at hand. Consequently, it indicates that the market is flawless and that gaining excessive profits from it is virtually impossible. Therefore, any technical analysis, fundamental analysis, or insider information not in the public domain would be considered irrelevant.
Limitations of Efficient Market Hypothesis
Since many investors have successfully outperformed the market rate of return over extended periods, the notion has numerous critics. For example, Warren Buffet invested in undervalued stocks and became a billionaire.
Additionally, abrupt market movements show that new information must be incorporated more effectively.
Why is the Efficient Market Hypothesis important for investors?
Why bother investing if it’s impossible or difficult for investors to outperform benchmarks? The Efficient Market Hypothesis was not intended to discourage investment. The exact opposite!
According to the EMH, investing in the entire market is the only way for investors to profit consistently over an extended period. To put it another way, the Efficient Market Hypothesis suggests that investing in low-cost, widely diversified, passively managed index funds is probably the wisest course of action.
This “old” theory of efficient markets might be more accurate today than it was when it was first proposed, given the development of algorithms and computers that can process information and transactions at lightning speeds, leading to a ‘strong form’ of markets.
Some traders will support the EMH if they can’t predict the stock market. But short-term traders can disagree with EMH’s theories since they think they can accurately foresee stock price fluctuations.
A passive, buy-and-hold, long-term approach is beneficial for the majority of investors. This is because most price fluctuations in the capital markets are random upward and downward movements.
What can make markets more efficient?
Let’s focus on establishing an efficient market rather than criticizing the theory. A market will grow more efficiently as more individuals participate, compete, and bring more varied information to bear on the price. Arbitrageurs will also emerge when markets grow more active and liquid, benefiting by addressing minor inefficiencies wherever they appear and swiftly restoring efficiency.
Conclusion
According to the efficient markets hypothesis (EMH), as everything is already reasonably and accurately priced, there is no room for investing to generate excess gains. This suggests that there is minimal chance of outperforming the market. However, passive index investing can help you match market returns.
Disclaimer
- This blog is exclusively for educational purposes
- Investments in the securities market are subject to market risks; read all the related documents carefully before investing
