The dream of many investors is to strike it rich in the stock market by picking that one stock everyone is overlooking. They want to actively pursue hidden gems and make a fortune while everyone else misses the details. However, that might be the wrong way to go about it. At least that’s according to people who subscribe to the Efficient Market Hypothesis (EMH). For many people who follow this theory, passive is the attitude to have. But does the EMH theory hold water, or is it an outdated strategy?
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What Is Efficient Market Hypothesis (EMH)?
The Efficient Market Hypothesis (often shortened to EMH) or efficient markets theory states that the stock prices you see for a company’s shares represent all the accurate information you need to know for that stock. In other words, when trading for a stock, you’ll always receive a fair value for it. That means investors can’t purchase stocks at a lower true value or sell stocks at a value higher than they’re actually worth.
According to the efficient markets theory, while investors might seek to outperform the stock market through savvy selections or right timing, they would actually be better off going with a passive, low-risk approach. The Efficient Market Hypothesis states that while some investors may get lucky from time to time, you can’t “beat” the market, and it’s best to play things safe.
Understanding Efficient Market Hypothesis (EMH)
The idea behind EMH first emerged from a book by Eugene Fama called Efficient Capital Markets: A Review of Theory and Empirical Work. Through his research, Fama determined that any investor who seemingly beat the market had largely gotten lucky and that the result would only be short-term gains. Fama insisted that applying that same strategy over the long-term would not yield a profit any higher than what one would see from the market average.
According to Fama’s fundamental analysis, EMH states that the price of the stock shows all the available information for that stock. While someone might try to gain an advantage through their own in-depth analysis, such an advantage would be temporary and unpredictable. EMH also indicates that the market is right and normal, whereas people who outperform it are the outliers. While EMH recognizes people may get lucky from time to time, it also says that people will also get unlucky. The gainers balance out the losers. For the vast majority of investors, they’ll stay at around the midway point, experiencing average gains.
Investors’ Beliefs on EMH: A Look Inside the Debate
To call the efficient markets hypothesis controversial would be an understatement. Although many professors still teach the idea in finance classes, many experts disagree with it.
One thing to understand is that efficient market theory is just that—a theory. While supporters of EMH might point to some evidence that it’s true, it’s not 100 percent proven. In fact, many financial analysts intensely disagree with it, often due to their own technical analysis and life experience.
Detractors point out that saying a stock price reflects all information about it is simply untrue. Many investors, experts in finance, and corporations have access to information not readily available to the public at large. Therefore, it’s reasonable to assume stock prices don’t match public information.
Economist Robert Haugen explains his criticism of EMH, saying, “[P]eople still go around saying there is a ‘mountain’ of evidence supporting their hypothesis, the truth of the matter is that it’s a very old mountain that’s now eroding rapidly into the sea.” Finance professional Naved Abdali adds to this, stating, “Over the long term, and I mean a very long term, markets are efficient. Prices do adjust to risk associated with returns. However, in the short-term, market prices are not rationally modified to all available information.”
Other detractors point to the stock market crash of 1987 as evidence EMH doesn’t hold true. As that crash shows, stock prices can be different from what their actual values are. As famed investor James Anderson says, “Personally, I lost any belief in the twin notions of predictability and efficiency on October 19, 1987. The S&P 500 losing 20 percent of its value on no news at all seemed a little hard to rationalize away.”
The Different Types of EMH
To better understand the Efficient Market Hypothesis, it’s important to note that investors and financial experts may subscribe to different types. This is another way of saying that the EMH theory has varying degrees of intensity, which are:
- Weak: Weak form market efficiency is when a stock price represents all data from past transactions. As a result, further analysis and new information will not yield more returns.
- Semi-strong: This efficiency theory maintains that while public information is used to determine stock value, some private data may help investors determine when it is a good time to invest in a particular stock to get the best returns.
- Strong: Strong form market efficiency is when all information, whether public or not, is used to determine stock prices. As a consequence, no one can gain more returns than others when investing.
Frequently Asked Questions About the Efficient Market Hypothesis
What Are the Pros and Cons of EMH?
One positive of EMH is that it provides a theory that allows more risk-averse individuals to feel more comfortable investing since they believe they don’t need insider knowledge or new information to get greater returns. Plus, as a theory, it helps people understand the market. Prior to it, many people simply shrugged their shoulders and said that luck or bad timing determined outcomes.
However, there are many cons associated with EMH. The first is that the theory hasn’t held up to real-world results (such as the 1987 crash). Information about stocks comes from so many different sources that to say the stock price accurately reflects value would be untrue. Different groups receive different sets of data from different sources. That’s not to mention that EMH attempts to spin the stock market as a rational, self-regulating entity when truthfully, the stock market is dependent on the people and companies involved in it.
What Is Market Efficiency?
The phrase “market efficiency” involves prices that accurately represent all available data. When a market is fully efficient, no one can truly beat it. All the information one needs to make a decision is already represented in the price. With better information, the market becomes even more efficient.
Did Warren Buffett Disprove the Efficient Market Hypothesis?
Warren Buffett is living proof EMH isn’t entirely accurate. As he once famously said, “I’d be a bum on the street with a tin cup if the markets were efficient.” Buffett’s record of successful investments shows that he has put in the work to “beat the market” averages. That’s not to say that he has completely disproved the theory, but he shows that with patience, the right information, and experience, others can beat market averages as well.
What Happens When Markets Are Inefficient?
When a market is inefficient, stock prices do not represent a true reflection of available information. The greater the disconnect, the more inefficient the market is. That means stock prices may be seriously undervalued and overvalued. Inflated prices compete with bargain prices, leading to opportunities for investors who are paying attention.
The Efficient Market Theory in Today’s World
While many investors disagree with the efficient markets hypothesis, some financial minds support it. They see it as a way to get people into investing in the first place. It provides structure newcomers can operate in as they get to know the markets.
If this still feels a bit too complicated, check out some other articles about investing.