Investing > Efficient Market Hypothesis Explained

Efficient Market Hypothesis Explained

The efficient market hypothesis states that you can’t reliably outperform the market. But is that true?

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Updated January 09, 2022

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Do you want to beat the market?

Of course, you do – although the average returns of the stock market are nothing to scoff at, the more the merrier. Why stop there? 

But, there’s just a tiny issue with that goal – beating the markets is tough. 😓

In fact, there is some empirical evidence to suggest that in the long run, nobody can beat the markets reliably. We’re talking about the efficient market hypothesis – a long-standing (but often challenged) piece of financial theory.

In essence, this theory claims that the price you see when looking at a security is always a fair representation of its underlying value – there’s no way to buy undervalued stocks and sell them at a profit, or to buy overvalued stocks and sell them before they deflate. However, recent events such as the GME short squeeze have shown us how prices can rapidly deviate from real value. 🚀

Now, obviously, something of this caliber has great implications. And the efficient market hypothesis has had a great effect on investment strategies since it was first put forth in the 1970s. If the hypothesis holds water, you’re going to have to factor it in when making investment decisions.

However, the jury’s still out. While there has been a lot of empirical research on the subject, there’s still no definite answer. We’ll let you draw your own conclusions – but first, we have to get acquainted with the topic of debate.

What you’ll learn
  • What Is Efficient Market Hypothesis?
  • The 3 Types of EMH
  • Is the Efficient Market Hypothesis Plausible?
  • EMH Investing Strategies
  • The Impact of Efficient Market Hypothesis
  • Conclusion
  • FAQs
  • Get Started with a Stock Broker

What is the Efficient Market Hypothesis? 📚 

To put it in the simplest possible terms, the efficient market hypothesis states that the price of a security is a fair representation of its value. Right off the bat, this depends greatly on a few simple conditions – that all relevant information regarding a security is free, widely available to the public, and universally shared.

Now, this is where the first disagreements arise. Theorists aren’t in agreement whether or not information actually is free, widely available, and shared – but we’ll deal with the criticisms later.

The efficient market hypothesis is often stated to hail from Eugene Fama’s acclaimed paper titled Efficient Capital Markets: A Review of Theory and Empirical Work, published in 1970. 

However, while Fama’s work might be the most influential and widely cited, the theory actually draws roots from the work of earlier mathematicians such as Benoit Mandelbrot and Julius Regnault’s random walk model. Other economists that have contributed to this line of thinking include William Sharpe, Harry Markowitz, Jack Treynor, and Myron Scholes.

In fact, the efficient market hypothesis might be much older than we anticipated – with Benoit Mandelbrot, one of the more influential theorists that worked on EMH claiming that it was first proposed way back in 1900 by Louis Bachelier.

However, we can say with certainty that the theory gained traction in the 1960s and 1970s, particularly with the advent of computers, which made large-scale statistical analysis more feasible.

Understanding Market Efficiency 📝

So, just what is market efficiency exactly? Well, market efficiency is a measure of information dispersion in a market. To put it in the simplest terms possible, market efficiency is the degree to which a market’s prices reflect all available information. 

In order for a market to be completely efficient, all information has to be transmitted to all market participants instantly, completely, perfectly, and free of charge. This results in a market where all prices are an accurate reflection of value – meaning that it is impossible to consistently beat the market in the long run.

The 3 Types of Efficient Market Hypothesis 🗃

The key to understanding why EMH is so widely debated to this day is the fact that the theory isn’t a monolith – different theorists have at times proposed different forms of the hypothesis, and research has been carried out on all of these variations.

We’re going to cover the three most important variations – the strong, semi-strong, and weak forms of the EMH.

Weak Form 📂

The weak form of the efficient market hypothesis posits that all past information regarding a security is figured into the stock price. This means that technical analysis is impossible and that all stock chart patterns aren’t a reliable way of telling whether or not a trend is occurring.

Now, keep in mind that all of this past information or historical data is public – however, this still leaves the door for new information that hasn’t yet become public knowledge. In other words, fundamental analysis can still work in this theoretical framework – however, most proponents of this form of the theory still believe that this can’t be used to consistently beat the market.

Semi-Strong Form 🕵️‍♂️

The semi-strong form of the efficient market hypothesis incorporates the same framework as the weak form does – along with one more important stipulation. The proponents of this form of the theory claim that, because the market rapidly adjusts to new information becoming public, even superior fundamental analysis cannot be used to beat the markets.

However, if you can get your hands on some information that isn’t available to the public, that should be enough to give you an edge. However, this isn’t to say that this is a simple workaround – the question of whether or not that would be enough to consistently outperform the market still stands. Plus, there’s always the question of legality (does insider trading ring any bells)?

Strong Form 💪

The strong form of EMH is the most controversial and disputed. It states that all information, whether public or private, is already accounted for in the price of a security. Outperforming the market, in the long run, is impossible.

Now, you might have noticed that we always say that EMH posits that outperforming the market reliably or in the long run is impossible. There’s an important distinction to make here – you can outperform the market by sheer luck, and EMH doesn’t state that some investors won’t get bigger returns than others – but a methodology by which one can accurately predict price movements is impossible.

Is the Efficient Market Hypothesis Plausible?

The efficient market hypothesis is far from universally accepted. The ability of investors to beat the market has been a topic of study since the 1930s, when Alfred Cowles’s research showed that, in general, professional investors couldn’t outperform the market at large.

However, there has been a lot of research since then, and we have quite a few examples of famous investors who disagree with this theory. Chief among them, Warren Buffet, who himself has managed to beat the markets reliably, George Soros, and Jim Simons.

Empirical evidence generally refutes the strong forms of EMH. Research from David Dreman and Michael Berry suggests that stocks with low P/E exhibit higher returns. Morningstar’s research which covered 3,500 active funds suggests that in 2020, 49% of them outperformed their average passive counterparts.

VGT tech stock ETF
The VGT tech stock ETF is just one of many funds that has been consistently outperforming the S&P 500 for years. Image by TradingView.

Behavioral economists dispute the efficiency of the market, attributing the lack of efficiency to cognitive biases and herd behavior. Plenty of economists point to the 2008 crisis as irrefutable proof that the EMH doesn’t hold water – as it gives an obvious example of asset prices that had little to do with real value, while other experts point to cryptocurrencies as a refutation of EMH.

And this criticism doesn’t only come from academic circles – former Fed chairman Paul Volcker attributed at least some of the cause of the 2008 financial crisis to “an unjustified faith in market efficiencies.” Eventually, even the father of EMH himself, Eugene Fama, acquiesced and admitted that markets can act “somewhat”  irrationally due to ill-informed investors.

EMH Investing Strategies 💰

The efficient market hypothesis has far-reaching consequences, even if you take it in its weakest form. Obviously, if you’re leaning toward accepting this theory, it will have a huge effect on your investment strategy – but even if you’re a proponent of the weaker forms, you’ll have to make certain adjustments.

To put it plainly, if we accept EMH at face value, a ton of investment strategies simply don’t make sense. For starters, you can forget about day trading – in fact, any sort of short-term strategy that depends on technical analysis is nonviable if you accept the EMH. Finding undervalued stocks is also a no-go,

So, what can you do if you accept this theory? Well, EMH lends itself to long-term, buy-and-hold investing, for starters. Since beating the markets isn’t an option, you’re left with passive investing. 

In particular, focusing on broad market ETFs, mutual funds, and index funds provides you with a good opportunity to recreate the average gains of stock market, which is the ideal outcome.

Pros

  • Easy to implement
  • Doesn’t require a lot of micromanagement and attention
  • Low transaction costs

Cons

  • Won’t produce above-average returns
  • Cannot react to market changes
  • Less control over your investments

The easiest way to conduct this strategy, rather than making your portfolio manually, is to get professional help—which is what many passive investors do. All robo-advisors subscribe to EMH to a certain extent and make strategies that try to follow the performance of the markets overall.

This is why so many young people and students use robo advisors like Acorns. In summary, the service itself automizes your entire investing process and gives you some extra boons that help you manage your finances—combined with the safety and reliability of EMH, this is one of the easiest forms of passive investing today.

The Impact of Efficient Market Hypothesis 👨‍🏫

The efficient market hypothesis is one of the most important pieces of financial theory in the 20th century. It, along with modern portfolio theory, has more or less completely shaped the way we look at asset allocation and risk management today.

The rise in the popularity of these two theories has led to the prevailing dominance of passive, index-fund-based approaches to investing for retirement. The huge popularity of hands-off, passive investment approaches and vehicles, such as ETFs and mutual funds also speaks to the huge effect that the EMH has had on the investment world.

On top of that, the EMH has led to an overall decrease in the demand for actively managed funds. Whether or not we accept this theory as a whole, empirical evidence has shown that money managers that are able to consistently generate above-average returns are rare.

This has led to a twofold effect on money managers – their services are in less demand as a whole, but on the other hand, the services of money managers with proven track records are all the more valuable.

Perhaps the greatest impact of the EMH can be seen in retirement planning. The typical approach to retirement planning nowadays eschews above-average returns, instead looking to construct a reliable, low-risk portfolio that matches the market.

Conclusion 🚩

Thanks for sticking with us until the end. We hope we’ve been able to efficiently relay this information to you. Although this is a highly contested piece of financial theory, it was and remains very influential – you should definitely be familiar with the basic tenets.

Even if you don’t agree with this theory, the investment strategies that are supported by it are still sound. If you’re risk-averse, pay attention to what proponents of the EMH are saying – and you’re sure to find a low-cost, passive investing approach that meets your needs.

Efficient Market Hypothesis: FAQs

  • What Is the Importance of Efficient Market Hypothesis?

    The efficient market hypothesis states that producing above-average returns on a reliable basis is impossible. If this is true, then active investing doesn’t make sense, and investors should focus on passive investing, index funds, and broad market ETFs.

  • What Are an Efficient and an Inefficient Market?

    In an efficient market, the price of a security is an accurate representation of its real value. In an inefficient market, due to lower information dispersal, an asset’s price isn’t reflective of its true value.

  • How Do You Make Money in an Efficient Market?

    In an efficient market, your best bet is adopting a passive approach that seeks to recreate the performance of the market. Index funds, ETFs, and mutual funds are your best bet if you want to achieve this.

  • How Do You Determine If a Market Is Efficient?

    If all of the relevant information regarding an asset is accurate, free, universally available, and instantly transmitted, then a market is efficient, because all of these factors have been taken into account when determining prices.

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All reviews, research, news and assessments of any kind on The Tokenist are compiled using a strict editorial review process by our editorial team. Neither our writers nor our editors receive direct compensation of any kind to publish information on tokenist.com. Our company, Tokenist Media LLC, is community supported and may receive a small commission when you purchase products or services through links on our website. Click here for a full list of our partners and an in-depth explanation on how we get paid.

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