Efficient-market hypothesis (EMH)
The Efficient-market hypothesis (EMH) is a financial theory asserting that asset prices, particularly stocks, reflect all available information, thus suggesting that it is impossible to consistently achieve higher returns than the overall market. The EMH categorizes into three forms: weak, semi-strong, and strong, each defining how different types of information are incorporated into stock prices. While proponents argue that the EMH serves as a useful approximation of market behavior—especially as information dissemination and trading technologies improve—critics highlight its limitations, particularly in accounting for irrational investor behavior and market anomalies. Notable figures like Warren Buffett have voiced skepticism, pointing to instances where investors have outperformed the market, suggesting that stock prices may not always reflect their true value. The hypothesis has significant implications for investment strategies, often leading to recommendations for diversified portfolios over attempts to pick individual stocks. Despite its challenges, the EMH remains influential in understanding market dynamics, especially in short-term assessments.
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Efficient-market hypothesis (EMH)
The efficient-market hypothesis (EMH) is an economic doctrine about prices, particularly the prices of stocks and other securities. The hypothesis asserts that the price of a stock is closely related to its underlying value. Although the classic form of the EMH applies to stocks, it has been applied to other types of markets as well. The EMH does not claim that the stock market is perfectly efficient or that the price reflects only the exact underlying value of the asset; indeed, barriers to trading or the sharing of financial information are thought to reduce the efficiency of a market. However, supporters argue that even though the EMH is not true in the strictest sense, it is highly accurate as an approximation. It has been claimed, with the increasing computerization of the market and the growing speed with which information is transmitted, the EMH is becoming more valid over time.
Brief History
The EMH has roots in nineteenth-century science and economics. A similar concept was put forth in the 1900 dissertation of French mathematician Louis Bachelier, who argued that speculators could not anticipate returns over time based on past performance, but his work in economics was completely neglected for decades. In its modern form, the EMH is usually traced to the work of American economist Eugene F. Fama, particularly in his 1970 article in the Journal of Finance, "Efficient Capital Markets: A Review of Theory and Empirical Work." Fama and those economists whose work he synthesized have gone on to produce a number of articles and studies supporting the EMH and random walk theory, and Fama was awarded the Nobel Prize in Economic Sciences in 2013.
The EMH is frequently subdivided into a weak, a semi-strong, and a strong or radical form. The weak form states that the current price of a stock reflects publicly available relevant information. The moderate form states that the price adjusts when new information, such as previously private information, becomes publicly available. The most radical form of the EMH makes no distinction between public and private information and asserts that the price of a stock incorporates all relevant information, including insider or other privately held information. The EMH appeals to economists who place a high value on markets as agglomerators of information. Others, including American Nobel Prize winner Paul A. Samuelson, have claimed that the EMH is a relatively accurate description of the price of individual stocks but not of the market as a whole.
Overview
The EMH is not just an academic theory. It has highly significant implications for investors. Since the price of a stock already incorporates all available information, supporters of the EMH argue that attempting to find "undervalued" stocks is fruitless and that daily variations in the price of a stock are more likely to be random. (The normal process by which stock prices change in accordance with only new, unpredictable information is often referred to as a "random walk.") This is frequently expressed in the saying that it is impossible to "beat the market." The only real choice an investor faces is the degree of risk they want. Supporters of the EMH often recommend a diverse portfolio of stocks (such as index funds) rather than trying to pick individual stocks. The EMH has also been used to criticize the high compensation paid to fund managers, who, according to the EMH and many empirical studies, lack the capacity to consistently exceed market averages.
The EMH is also commonly held to imply that a stock’s past movements have no effect on its future movements. Supporters of the EMH and random walk hypotheses shun technical analysis, which traces and charts the patterns of a stock price’s rise and fall to predict its future movements. Fundamental analysis, based on examining a corporation’s balance sheets and other documents to determine whether its stock is overpriced or underpriced is also useless, although some EMH supporters are willing to allow it a limited role.
The EMH does not require that every individual investor be rational, as long as investors in the market overall act rationally based on new information. Critics from the behavioral economics school have claimed that it does not give proper weight to the irrational factors in economic decisions, such as the bandwagon effect (when investors buy a stock because they perceive other investors, particularly investors respected for their expertise, as doing so). Critics also argue that stocks might not have one true price if they are rationally evaluated by different investors based on different criteria. Even though information may be publicly available, investors have different degrees of access to it, ability to understand its relevance to stock value, and cognitive biases, such as hindsight bias. Critics have also made the empirical argument that investors have exceeded market averages ("beat the market") over an extended period of time—especially by buying "value" stocks, whose true worth is supposedly underestimated—in spite of the EMH maintaining that this is impossible. The famous American investor Warren Buffett is often invoked in this context. Bubbles (market highs in which stocks are systematically overvalued) and stock market crashes affecting a broad range of stocks are also difficult to explain through the EMH. This is taken to show that EMH may not be as accurate over longer time scales like years and decades, but it does appear to be valid for assessing price trends over shorter periods like weeks and months.
Paradoxically, the EMH may be becoming more valid as the search for anomalies (recurrent movements in stock prices that seem not to conform to the EMH) succeeds. As anomalies are discovered, they become part of the knowledge base of investors, who, by incorporating them into their decisions, make them part of the information that determines stock prices according to the EMH.
Bibliography
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