Are markets efficient? The efficient market hypothesis explained
Rebecca Cattlin November 4, 2021 9:00 AM
Many investors aim to ‘beat the market’ by earning more profit than average. However, proponents of the efficient market hypothesis would tell you that this is impossible. Let’s take a look at the EMH and whether its implications are true or not.
What is the efficient market hypothesis?
The efficient market hypothesis (EMH) is an investment theory that states it’s impossible to consistently outperform the overall market, or ‘beat the market’. The theory is based on the assumption that all relevant information will be ‘universally shared’ and so securities always trade at their fair market value.
The idea was put forward by Eugene Fama in his 1970 book titled ‘Efficient Capital Markets: A Review of Theory and Empirical Work’ where he stated no one could continuously make investment returns over and above an average benchmark, such as the S&P 500. He conceded that an investor might manage to find a stock to bring them short-term profits, but over the long term, there’s no way to bring in higher-than-average returns.
What is the strong form efficient market hypothesis?
Strong form EMH is a version of the theory that states all information about a stock – both public and private – is completely accounted for by the market, so there is no way an investor can achieve above-average returns.
What is the semi-strong form efficient market hypothesis?
Semi-strong form EMH is a slightly diluted version of the theory, which states that all public information is priced into market prices so the only way an investor can boost their returns is to use information that is not available to the public.
What is the weak form efficient market hypothesis?
Weak form EMH suggests that stock prices reflect all historical data, so no technical analysis will be able to create outsized returns. However, it does concede that fundamental analysis can be used to identify undervalued and overvalued shares to increase their chances of beating the market.
What are the implications of the efficient market hypothesis?
The main implication of the efficient market hypothesis is that stocks always trade at their fair value, meaning a company’s shares can never be overvalued or undervalued. If the theory is true it would be impossible for a trader or investor to ‘beat the market’ because any information that could be used to predict market movements is already priced in.
However, we know that the market doesn’t respond like this in a large part due to the psychology of individual participants. Traders can overreact to new information, which can cause price swings – both positively and negatively.
Arguments against the efficient market hypothesis
One of the main arguments against EMH is the occurrence of stock market bubbles and market crashes. The very fact that share prices can rise so high and fall so rapidly is a clear indication that shares don’t always trade at their fair value.
For example, the dot-com bubble saw internet companies’ share prices rise to extreme heights in just a couple of years – the valuations were not based on income, but on optimism that these tech firms would experience growth. When the bubble burst, it caused a global bear market as traders rushed out of their positions. Share prices went from one extreme to the other, based on market sentiment rather than fundamentals.
Fama did concede that the EMH wouldn’t work 100% of the time because random events will always occur, but he did say that prices would always correct. However, the EMH doesn’t include any definitive timeframe for how long it would take time for markets to respond, so there is no way to know when the EMH would consider a market price ‘fair’.
Another criticism of the EMH is that investors don’t always respond in the same way to information due to differences in valuation methods – some look at the value of a stock, others look at growth opportunities.
And a final criticism is that we have very prevalent examples of people who have beaten the market. You just have to look at famous investors like Warren Buffet to see that one investor can achieve large returns while others can’t. Under EMH, if one investor is profitable then the market as a whole will be – but this just isn’t true. The only way the theory believes individuals can make outsized returns is through pure speculation, as no fundamental or technical analysis can guarantee results.
Summary: are markets efficient?
There is a growing belief that markets are more efficient now than they have ever been thanks to the rise of computerised algorithms and the ease at which information about shares is available. However, as most decisions are still made by individuals, there is always room for error. Human emotions like greed and fear are known to get the better of investors, which still leads to market anomalies.
We can see an ‘inefficient’ market movement in the recent Reddit stocks trend, in which retail investors using the r/WallStreetBets forum were able to increase the value of GameStop and other shares well beyond their true value.
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