You may not have heard of the Efficient Market Hypothesis before, also known as EMH, but you’ve probably wondered why even the most experienced mutual fund portfolio managers and other professional investors often lose to the major market indexes. EMH will help explain this investing phenomenon. This article focuses on what efficient market hypothesis is all about.
Definition of Efficient Market Hypothesis
The Efficient Market Hypothesis (EMH) is an investment theory that essentially states that all known information about investment securities is already into the prices of those securities. Also, it states it is impossible to “beat the market” because stock market efficiency causes existing share prices to always incorporate and reflect all relevant information.
According to the EMH, stocks always trade at their fair value on stock exchanges, making it impossible for investors to either purchase undervalued stocks or sell stocks for inflated prices. As such, it should be impossible to outperform the overall market through expert stock selection or market timing, and the only way an investor can possibly achieve higher returns is by purchasing riskier investments.
Therefore, assuming this is true, no amount of analysis can give an investor an edge over other investors. EMH does not require that investors be rational. Instead, it says that individual investors will act randomly, but as a whole, the market is always “right.” In simple terms, “efficient” implies “normal.” For example, an unusual reaction to unusual information is normal.
Forms of Efficient Market Hypothesis
There are three forms of EMH: Weak, Semi-strong and Strong. Here’s what each says about the market.
Weak Form EMH
This form suggests that all past information is priced into securities. Fundamental analysis of securities can provide an investor with information to produce returns above market averages in the short term, but there are no “patterns” that exist. Therefore, the fundamental analysis does not provide a long-term advantage and technical analysis will not work.
Semi-Strong Form EMH
This form implies that neither fundamental analysis nor technical analysis can provide an advantage for an investor and that new information is instantly priced into securities. Nevertheless, this is the most interesting in the case of investors because, that is exactly the information that they have access to, so if semi-strong EMH is true, then it is useless for us to analyze stocks in an attempt to separate winners from losers.
Strong Form EMH
This form says that all information, both public and private, is priced into stocks and that no investor can gain an advantage over the market as a whole. Strong Form EMH does not say some investors or money managers are incapable of capturing abnormally high returns, but that there are always outliers included in the averages.
Therefore, it is illegal to use insider information for trading, as it would mean insiders taking profits from the general public and thus pushing them away from stock trading, something that society doesn’t want.
More on Forms of EMH
Proponents of EMH, even in its weak form, often invest in index funds or certain ETFs because they are passively managed (these funds simply attempt to match, not beat, overall market returns). Index investors might stick to the common saying “If you can’t beat ’em, join ’em.” Instead of trying to beat the market, they will buy an index fund that invests in the same securities.
With that said, there will still be investors who will beat the market averages. However, these investors are in the minority and it is arguable that at least some part of their success can be attributable to luck.
EMH shouldn’t give in to a thinking that there is no such thing as investment-portfolio design. There are still important decisions to make in order to get a portfolio with a risk that suits you; a good (expected) reward for that risk, and the lowest possible costs meaning commissions and other fees.
See Also: All About Market Analysis
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