Efficient Markets Hypothesis (EMH)

DEFINITION of Efficient Markets Hypothesis (EMH)

Efficient Markets Hypothesis (EMH) is an investment theory.

WHAT IT IS IN ESSENCE

Primarily derived from concepts attributed to Eugene Fama’s research work as detailed in his 1970 book, “Efficient Capital Markets: A Review of Theory and Empirical Work”. Fama put forth the basic idea that it is virtually impossible to consistently “beat the market”. In order to make investment returns that outperform the overall market average as reflection by major stock indexes such as the S&P 500 Index.

According to Fama’s theory, an investor might get lucky and buy a stock that brings him huge short-term profits. But over the long term, he cannot realistically hope to achieve a return on investment that is substantially higher than the market average.

Fama’s based his investment theory on a number of assumptions about securities markets and how they function.

These assumptions include the one idea critical to the validity of the efficient markets hypothesis. The belief that all information relevant to stock prices is freely and widely available, “universally shared” among all investors.

As there are always a large number of both buyers and sellers in the market, price movements always occur efficiently. Like in a timely, up-to-date manner. Thus, stocks are always trading at their current fair market value. The major conclusion of the theory is that stocks are always traded at their fair market value.

So, it is virtually impossible to either buy undervalued stocks at a bargain or sell overvalued stocks for extra profits. Neither expert stock analysis nor market timing strategies can hope to average doing any better than the performance of the overall market.

If that’s true, then the only way investors can generate superior returns is by taking on much greater risk.

There are three variations of the hypothesis: the weak, semi-strong, and strong forms. They represent three different assumed levels of market efficiency.

HOW TO USE

Supporters of the EMH often argue their case based either on the basic logic of the theory or on a number of studies that have been done that seem to support it.

Opponents of the efficient markets hypothesis point the simple fact that there are traders and investors who do consistently, generate returns on investment that dwarf the performance of the overall market.

According to the EMH, that should be impossible other than by blind luck. Frankly, blind luck can’t explain the same people beating the market by a wide margin, over and over again over a long span of time.

Those who argue that the EMH theory is not a valid one point out that there are indeed times when excessive optimism or pessimism in the markets drives prices to trade at excessively high or low prices. It is clearly showing that securities do not always trade at their fair market value.

Investors who subscribe to the EMH are more inclined to invest in passive index funds and less willing to pay high fees for expert fund management.

The research in support of the EMH has shown how rare money managers who can consistently outperform the market are. The few individuals who have developed such a skill are ever more sought after and respected.