For a number of years, it has been a huge debate among stock market investors whether the market is actually efficient – that is, whether it fully reflects all available information through the current stock prices or not, thus opening the possibility for undervalued and overvalued stock prices. In this article, we are going to talk on what efficient market hypothesis is all about.
What is Efficient Market Hypothesis?
Efficient Market Hypothesis or EMH is an investment theory developed by Professor Eugene Fama in the 1960s. It concludes that the market consistently operates efficiently. The theory states that it is impossible to “beat the market” because the current share prices already fully reflect all relevant information about the shares.
According to the EMH, stocks always trade on stock exchanges at their fair value, thus making it impossible to buy undervalued or overvalued stocks. It also states that it is impossible to outperform the market by expert stock selection or market timing. The only way to get high returns from the market is by purchasing riskier investments. The theory implies that you’re engaging in a game of chance each time you buy and sell securities instead of investing using your skills.
For years, EMH has been a cornerstone of modern financial theory, but it is highly controversial and often disputed especially since a lot of investors like Warren Buffet have proved to consistently beat the market over long periods of time.
However, supporters of the EMH model still believe that it is pointless to search for undervalued stocks or to predict the market trend by doing fundamental and technical analysis. They conclude that investing in a low-cost, passive portfolio is the only best way to get the upper hand in a volatile market.
Variants of the EMH
Weak form – assumes that the current stock prices fully reflect all currently available market data. It also states that the past prices and volume information don’t have any connection to the probable future direction of the security price. This form concludes that the excess returns cannot be achieved through technical analysis.
Semi-strong form – assumes that the current stock prices rapidly adjust to the release of all new public data. It also states that security prices are taken from available market and non-market public information. This form concludes that the excess returns cannot be achieved through fundamental analysis.
Strong form – assumes that the current stock prices fully reflect all public and private data available. It states that market, non-market, and even inside information all contribute to the prices of the securities and that no one has sole exploitative access to relevant information. The strong form assumes a perfect market and concludes that excess returns are impossible to achieve consistently.
Despite the thought that the market always operate efficiently, in reality, it does not consistently behave that way. Believers of the theory could not come up of any explanation as to why the market goes through periods of volatility. Another deterrent of the theory are the countless times when investors prove to the possibility of beating the market. Despite these, the efficient market hypothesis still remains a prominent theory in financial economics.
Read more about market volatility.
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