Efficient Market Hypothesis (EMH)
Written by True Tamplin, BSc, CEPF®
Reviewed by subject matter experts.
Updated on July 12, 2023
Are You Retirement Ready?
Table of contents, efficient market hypothesis (emh) overview.
The Efficient Market Hypothesis (EMH) is a theory that suggests financial markets are efficient and incorporate all available information into asset prices.
According to the EMH, it is impossible to consistently outperform the market by employing strategies such as technical analysis or fundamental analysis.
The hypothesis argues that since all relevant information is already reflected in stock prices, it is not possible to gain an advantage and generate abnormal returns through stock picking or market timing.
The EMH comes in three forms: weak, semi-strong, and strong, each representing different levels of market efficiency.
While the EMH has faced criticisms and challenges, it remains a prominent theory in finance that has significant implications for investors and market participants.
Types of Efficient Market Hypothesis
The Efficient Market Hypothesis can be categorized into the following:
Weak Form EMH
The weak form of EMH posits that all past market prices and data are fully reflected in current stock prices.
Therefore, technical analysis methods, which rely on historical data, are deemed useless as they cannot provide investors with a competitive edge. However, this form doesn't deny the potential value of fundamental analysis.
Semi-strong Form EMH
The semi-strong form of EMH extends beyond historical prices and suggests that all publicly available information is instantly priced into the market.
This includes financial statements, news releases, economic indicators, and other public disclosures. Therefore, neither technical analysis nor fundamental analysis can yield superior returns consistently.
Strong Form EMH
The most extreme version of EMH, the strong form, asserts that all information, both public and private, is fully reflected in stock prices.
Even insiders with privileged information cannot consistently achieve higher-than-average market returns. This form, however, is widely criticized as it conflicts with securities regulations that prohibit insider trading .
Assumptions of the Efficient Market Hypothesis
Three fundamental assumptions underpin the Efficient Market Hypothesis.
All Investors Have Access to All Publicly Available Information
This assumption holds that the dissemination of information is perfect and instantaneous. All market participants receive all relevant news and data about a security or market simultaneously, and no investor has privileged access to information.
All Investors Have a Rational Expectation
In EMH, it is assumed that investors collectively have a rational expectation about future market movements. This means that they will act in a way that maximizes their profits based on available information, and their collective actions will cause securities' prices to adjust appropriately.
Investors React Instantly to New Information
In an efficient market, investors instantaneously incorporate new information into their investment decisions. This immediate response to news and data leads to swift adjustments in securities' prices, rendering it impossible to "beat the market."
Implications of the Efficient Market Hypothesis
The EMH has several implications across different areas of finance.
Implications for Individual Investors
For individual investors, EMH suggests that "beating the market" consistently is virtually impossible. Instead, investors are advised to invest in a well-diversified portfolio that mirrors the market, such as index funds.
Implications for Portfolio Managers
For portfolio managers , EMH implies that active management strategies are unlikely to outperform passive strategies consistently. It discourages the pursuit of " undervalued " stocks or timing the market.
Implications for Corporate Finance
In corporate finance, EMH implies that a company's stock is always fairly priced, meaning it should be indifferent between issuing debt and equity . It also suggests that stock splits , dividends , and other financial decisions have no impact on a company's value.
Implications for Government Regulation
For regulators , EMH supports policies that promote transparency and information dissemination. It also justifies the prohibition of insider trading.
Criticisms and Controversies Surrounding the Efficient Market Hypothesis
Despite its widespread acceptance, the EMH has attracted significant criticism and controversy.
Behavioral Finance and the Challenge to EMH
Behavioral finance argues against the notion of investor rationality assumed by EMH. It suggests that cognitive biases often lead to irrational decisions, resulting in mispriced securities.
Examples include overconfidence, anchoring, loss aversion, and herd mentality, all of which can lead to market anomalies.
Market Anomalies and Inefficiencies
EMH struggles to explain various market anomalies and inefficiencies. For instance, the "January effect," where stocks tend to perform better in January, contradicts the EMH.
Similarly, the "momentum effect" suggests that stocks that have performed well recently tend to continue performing well, which also challenges EMH.
Financial Crises and the Question of Market Efficiency
The Global Financial Crisis of 2008 raised serious questions about market efficiency. The catastrophic market failure suggested that markets might not always price securities accurately, casting doubt on the validity of EMH.
Empirical Evidence of the Efficient Market Hypothesis
Empirical evidence on the EMH is mixed, with some studies supporting the hypothesis and others refuting it.
Evidence Supporting EMH
Several studies have found that professional fund managers, on average, do not outperform the market after accounting for fees and expenses.
This finding supports the semi-strong form of EMH. Similarly, numerous studies have shown that stock prices tend to follow a random walk, supporting the weak form of EMH.
Evidence Against EMH
Conversely, other studies have documented persistent market anomalies that contradict EMH.
The previously mentioned January and momentum effects are examples of such anomalies. Moreover, the occurrence of financial bubbles and crashes provides strong evidence against the strong form of EMH.
Efficient Market Hypothesis in Modern Finance
Despite criticisms, the EMH continues to shape modern finance in profound ways.
EMH and the Rise of Passive Investing
The EMH has been a driving force behind the rise of passive investing. If markets are efficient and all information is already priced into securities, then active management cannot consistently outperform the market.
As a result, many investors have turned to passive strategies, such as index funds and ETFs .
Impact of Technology on Market Efficiency
Advances in technology have significantly improved the speed and efficiency of information dissemination, arguably making markets more efficient. High-frequency trading and algorithmic trading are now commonplace, further reducing the possibility of beating the market.
Future of EMH in Light of Evolving Financial Markets
While the debate over market efficiency continues, the growing influence of machine learning and artificial intelligence in finance could further challenge the EMH.
These technologies have the potential to identify and exploit subtle patterns and relationships that human investors might miss, potentially leading to market inefficiencies.
The Efficient Market Hypothesis is a crucial financial theory positing that all available information is reflected in market prices, making it impossible to consistently outperform the market. It manifests in three forms, each with distinct implications.
The weak form asserts that all historical market information is accounted for in current prices, suggesting technical analysis is futile.
The semi-strong form extends this to all publicly available information, rendering both technical and fundamental analysis ineffective.
The strongest form includes even insider information, making all efforts to beat the market futile. EMH's implications are profound, affecting individual investors, portfolio managers, corporate finance decisions, and government regulations.
Despite criticisms and evidence of market inefficiencies, EMH remains a cornerstone of modern finance, shaping investment strategies and financial policies.
Efficient Market Hypothesis (EMH) FAQs
What is the efficient market hypothesis (emh), and why is it important.
The Efficient Market Hypothesis (EMH) is a theory suggesting that financial markets are perfectly efficient, meaning that all securities are fairly priced as their prices reflect all available public information. It's important because it forms the basis for many investment strategies and regulatory policies.
What are the three forms of the Efficient Market Hypothesis (EMH)?
The three forms of the EMH are the weak form, semi-strong form, and strong form. The weak form suggests that all past market prices are reflected in current prices. The semi-strong form posits that all publicly available information is instantly priced into the market. The strong form asserts that all information, both public and private, is fully reflected in stock prices.
How does the Efficient Market Hypothesis (EMH) impact individual investors and portfolio managers?
According to the EMH, consistently outperforming the market is virtually impossible because all available information is already factored into the prices of securities. Therefore, it suggests that individual investors and portfolio managers should focus on creating well-diversified portfolios that mirror the market rather than trying to beat the market.
What are some criticisms of the Efficient Market Hypothesis (EMH)?
Criticisms of the EMH often come from behavioral finance, which argues that cognitive biases can lead investors to make irrational decisions, resulting in mispriced securities. Additionally, the EMH has difficulty explaining certain market anomalies, such as the "January effect" or the "momentum effect." The occurrence of financial crises also raises questions about the validity of EMH.
How does the Efficient Market Hypothesis (EMH) influence modern finance and its future?
Despite criticisms, the EMH has profoundly shaped modern finance. It has driven the rise of passive investing and influenced the development of many financial regulations. With advances in technology, the speed and efficiency of information dissemination have increased, arguably making markets more efficient. Looking forward, the growing influence of artificial intelligence and machine learning could further challenge the EMH.
About the Author
True Tamplin, BSc, CEPF®
True Tamplin is a published author, public speaker, CEO of UpDigital, and founder of Finance Strategists.
True is a Certified Educator in Personal Finance (CEPF®), author of The Handy Financial Ratios Guide , a member of the Society for Advancing Business Editing and Writing, contributes to his financial education site, Finance Strategists, and has spoken to various financial communities such as the CFA Institute, as well as university students like his Alma mater, Biola University , where he received a bachelor of science in business and data analytics.
To learn more about True, visit his personal website or view his author profiles on Amazon , Nasdaq and Forbes .
Related Topics
- AML Regulations for Cryptocurrencies
- Active vs Passive Investment Management
- Advantages and Disadvantages of Cryptocurrencies
- Aggressive Investing
- Asset Management vs Investment Management
- Becoming a Millionaire With Cryptocurrency
- Burning Cryptocurrency
- Cheapest Cryptocurrencies With High Returns
- Complete List of Cryptocurrencies & Their Market Capitalization
- Countries Using Cryptocurrency
- Countries Where Bitcoin Is Illegal
- Crypto Investor’s Guide to Form 1099-B
- Cryptocurrency Airdrop
- Cryptocurrency Alerting
- Cryptocurrency Analysis Tool
- Cryptocurrency Cloud Mining
- Cryptocurrency Risks
- Cryptocurrency Taxes
- Depth of Market
- Digital Currency vs Cryptocurrency
- Fundamental Analysis in Cryptocurrencies
- Global Macro Hedge Fund
- Gold-Backed Cryptocurrency
- How Much Does a Wealth Manager Make?
- How to Buy a House With Cryptocurrencies
- How to Cash Out Your Cryptocurrency
- Inventory Turnover Rate (ITR)
- Largest Cryptocurrencies by Market Cap
- Types of Fixed Income Investments
Ask a Financial Professional Any Question
Discover wealth management solutions near you.
We use cookies to ensure that we give you the best experience on our website. If you continue to use this site we will assume that you are happy with it.
Fact Checked
At Finance Strategists, we partner with financial experts to ensure the accuracy of our financial content.
Our team of reviewers are established professionals with decades of experience in areas of personal finance and hold many advanced degrees and certifications.
They regularly contribute to top tier financial publications, such as The Wall Street Journal, U.S. News & World Report, Reuters, Morning Star, Yahoo Finance, Bloomberg, Marketwatch, Investopedia, TheStreet.com, Motley Fool, CNBC, and many others.
This team of experts helps Finance Strategists maintain the highest level of accuracy and professionalism possible.
Why You Can Trust Finance Strategists
Finance Strategists is a leading financial education organization that connects people with financial professionals, priding itself on providing accurate and reliable financial information to millions of readers each year.
We follow strict ethical journalism practices, which includes presenting unbiased information and citing reliable, attributed resources.
Our goal is to deliver the most understandable and comprehensive explanations of financial topics using simple writing complemented by helpful graphics and animation videos.
Our writing and editorial staff are a team of experts holding advanced financial designations and have written for most major financial media publications. Our work has been directly cited by organizations including Entrepreneur, Business Insider, Investopedia, Forbes, CNBC, and many others.
Our mission is to empower readers with the most factual and reliable financial information possible to help them make informed decisions for their individual needs.
How It Works
Step 1 of 3, ask any financial question.
Ask a question about your financial situation providing as much detail as possible. Your information is kept secure and not shared unless you specify.
Step 2 of 3
Our team will connect you with a vetted, trusted professional.
Someone on our team will connect you with a financial professional in our network holding the correct designation and expertise.
Step 3 of 3
Get your questions answered and book a free call if necessary.
A financial professional will offer guidance based on the information provided and offer a no-obligation call to better understand your situation.
Where Should We Send Your Answer?
Just a Few More Details
We need just a bit more info from you to direct your question to the right person.
Tell Us More About Yourself
Is there any other context you can provide.
Pro tip: Professionals are more likely to answer questions when background and context is given. The more details you provide, the faster and more thorough reply you'll receive.
What is your age?
Are you married, do you own your home.
- Owned outright
- Owned with a mortgage
Do you have any children under 18?
- Yes, 3 or more
What is the approximate value of your cash savings and other investments?
- $50k - $250k
- $250k - $1m
Pro tip: A portfolio often becomes more complicated when it has more investable assets. Please answer this question to help us connect you with the right professional.
Would you prefer to work with a financial professional remotely or in-person?
- I would prefer remote (video call, etc.)
- I would prefer in-person
- I don't mind, either are fine
What's your zip code?
- I'm not in the U.S.
Submit to get your question answered.
A financial professional will be in touch to help you shortly.
Part 1: Tell Us More About Yourself
Do you own a business, which activity is most important to you during retirement.
- Giving back / charity
- Spending time with family and friends
- Pursuing hobbies
Part 2: Your Current Nest Egg
Part 3: confidence going into retirement, how comfortable are you with investing.
- Very comfortable
- Somewhat comfortable
- Not comfortable at all
How confident are you in your long term financial plan?
- Very confident
- Somewhat confident
- Not confident / I don't have a plan
What is your risk tolerance?
How much are you saving for retirement each month.
- None currently
- Minimal: $50 - $200
- Steady Saver: $200 - $500
- Serious Planner: $500 - $1,000
- Aggressive Saver: $1,000+
How much will you need each month during retirement?
- Bare Necessities: $1,500 - $2,500
- Moderate Comfort: $2,500 - $3,500
- Comfortable Lifestyle: $3,500 - $5,500
- Affluent Living: $5,500 - $8,000
- Luxury Lifestyle: $8,000+
Part 4: Getting Your Retirement Ready
What is your current financial priority.
- Getting out of debt
- Growing my wealth
- Protecting my wealth
Do you already work with a financial advisor?
Which of these is most important for your financial advisor to have.
- Tax planning expertise
- Investment management expertise
- Estate planning expertise
- None of the above
Where should we send your answer?
Submit to get your retirement-readiness report., get in touch with, great the financial professional will get back to you soon., where should we send the downloadable file, great hit “submit” and an advisor will send you the guide shortly., create a free account and ask any financial question, learn at your own pace with our free courses.
Take self-paced courses to master the fundamentals of finance and connect with like-minded individuals.
Get Started
To ensure one vote per person, please include the following info, great thank you for voting., get in touch with a financial advisor, submit your info below and someone will get back to you shortly..
By submitting my information, I agree to the Privacy Policy and Terms of Service .
Already have an account? Sign In
Forgot Password?
Don't have an account? Sign Up
What is Efficient Market Hypothesis? | EMH Theory Explained
The efficient market hypothesis (EMH) can help explain why many investors opt for passive investing strategies, such as buying index funds or exchange-traded funds ( ETFs ), which generate consistent returns over an extended period. However, the EMH theory remains controversial and has found as many opponents as proponents. This guide will explain the efficient market hypothesis, how it works, and why it is so contradictory.
Best Crypto Exchange for Intermediate Traders and Investors
Invest in cryptocurrencies and 3,000+ other assets including stocks and precious metals.
0% commission on stocks - buy in bulk or just a fraction from as little as $10. Other fees apply. For more information, visit etoro.com/trading/fees.
Copy top-performing traders in real time, automatically.
eToro USA is registered with FINRA for securities trading.
What is the efficient market hypothesis?
The efficient market hypothesis (EMH) claims that all assets are always fairly and accurately priced and trade at their fair market value on exchanges. If this theory is true, nothing can give you an edge to outperform the market using different investing strategies and make excess profits compared to those who follow market indexes.
Efficient market definition
An efficient market is where all asset prices listed on exchanges fully reflect their true and only value, thus making it impossible for investors to “beat the market” and profit from price discrepancies between the market price and the stock’s intrinsic value. The EMH claims the stock’s fair value, also called intrinsic value , is much the same as its market value , and finding undervalued or overvalued assets is non-viable.
Intrinsic value refers to an asset’s true, actual value, which is calculated using fundamental and technical analysis, whereas the market price is the currently listed price at which stock is bought and sold. When markets are efficient, the two values should be the same, but when they differ, it poses opportunities for investors to make an excess profit.
For markets to be completely efficient, all information should already be accounted for in stock prices and are trading on exchanges at their fair market value, which is practically impossible.
Hypothesis definition
A hypothesis is merely an assumption, an idea, or an argument that can be tested and reasoned not to be true. Something that isn’t fully supported by full facts or doesn’t match applied research.
For example, if sugar causes cavities, people who eat a lot of sweets are prone to cavities. And if the same applies here – if all information is reflected in a stock’s price, then its fair value should be the same as its market value and can not differ or be impacted by any other factors.
Beginners’ corner:
- What is Investing? Putting Money to Work ;
- 17 Common Investing Mistakes to Avoid ;
- 15 Top-Rated Investment Books of All Time ;
- How to Buy Stocks? Complete Beginner’s Guide ;
- 10 Best Stock Trading Books for Beginners ;
- 15 Highest-Rated Crypto Books for Beginners ;
- 6 Basic Rules of Investing ;
- Dividend Investing for Beginners ;
- Top 6 Real Estate Investing Books for Beginners ;
- 5 Passive Income Investment Ideas .
Fundamental and technical analysis in an efficient market
According to the EMH, stock prices are already accurately priced and consider all possible information. If markets are fully efficient, then no fundamental or technical analysis can help investors find anomalies and make an extra profit.
Fundamental analysis is a method to calculate a stock’s fair or intrinsic value by looking beyond the current market price by examining additional external factors like financial statements, the overall state of the economy, and competition, which can help define whether the stock is undervalued.
Also relevant is technical analysis , a method of forecasting the value of stocks by analyzing the historical price data, mainly looking at price and volume fluctuations occurring daily, weekly, or any other constant period, usually displayed on a chart.
The efficient market theory directly contradicts the possibility of outperforming the market using these two strategies; however, there are three different versions of EMH, and each slightly differs from the other.
Three forms of market efficiency
The efficient market hypothesis can take three different forms , depending on how efficient the markets are and which information is considered in theory:
1. Strong form efficiency
Strong form efficiency is the EMH’s purest form, and it is an assumption that all current and historical, both public and private, information that could affect the asset’s price is already considered in a stock’s price and reflects its actual value. According to this theory, stock prices listed on exchanges are entirely accurate.
Investors who support this theory trust that even inside information can’t give a trader an advantage, meaning that no matter how much extra information they have access to or how much analysis and research they do, they can not exceed standard returns.
Burton G. Malkiel, a leading proponent of the strong-form market efficiency hypothesis, doesn’t believe any analysis can help identify price discrepancies. Instead, he firmly believes in buy-and-hold investing, trusting it is the best way to maximize profits. However, factual research doesn’t support the possibility of a strong form of efficiency in any market.
2. Semi-strong form efficiency
The semi-strong version of the EMH suggests that only current and historical public (and not private) information is considered in the stock’s listed share prices. It is the most appropriate form of the efficient market hypothesis, and factual evidence supports that most capital markets in developed countries are generally semi-strong efficient.
This form of efficiency relies on the fact that public news about a particular stock or security has an immediate effect on the stock prices in the market and also suggests that technical and fundamental analysis can’t be used to make excess profits.
A semi-strong form of market efficiency theory accepts that investors can gain an advantage in trading only when they have access to any unknown private information unknown to the rest of the market.
3. Weak form efficiency
Weak market efficiency, also called a random walk theory, implies that investors can’t predict prices by analyzing past events, they are entirely random, and technical analysis cannot be used to beat the market.
Random walk theory proclaims stock prices always take a randomized path and are unpredictable, that investors can’t use past price changes and historical data trends to predict future prices, and that stock prices already reflect all current information.
For example, advocates of this form see no or limited benefit to technical analysis to discover investment opportunities. Instead, they would maintain a passive investment portfolio by buying index funds that track the overall market performance.
For example, the momentum investing method analyzes past price movements of stocks to predict future prices – it goes directly against the weak form efficiency, where all the current and past information is already reflected in their market prices.
A brief history of the efficient market hypothesis
The concept of the efficient market hypothesis is based on a Ph.D. dissertation by Eugene Fama , an American economist, and it assumes all prices of stocks or other financial instruments in the market are entirely accurate.
In 1970, Fama published this theory in “Efficient Capital Markets: A Review of Theory and Empirical Work,” which outlines his vision where he describes the efficient market as: “A market in which prices always “fully reflect” available information is called “efficient.”
Another theory based on the EMH, the random walk theory by Burton G. Malkiel , states that prices are completely random and not dependent on any factor. Not even past information, and that outperforming the market is a matter of chance and luck and not a point of skill.
Fama has acknowledged that the term can be misleading and that markets can’t be efficient 100% of the time, as there is no accurate way of measuring it. The EMH accepts that random and unexpected events can affect prices but claims they will always be leveled out and revert to their fair market value.
What is an inefficient market?
The efficient market hypothesis is a theory, and in reality, most markets always display some inefficiencies to a certain extent. It means that market prices don’t always reflect their true value and sometimes fail to incorporate all available information to be priced accurately.
In extreme cases, an inefficient market may even lead to a market failure and can occur for several reasons.
An inefficient market can happen due to:
- A lack of buyers and sellers;
- Absence of information;
- Delayed price reaction to the news;
- Transaction costs;
- Human emotion;
- Market psychology.
The EMH claims that in an efficiently operating market, all asset prices are always correct and consider all information; however, in an inefficient market, all available information isn’t reflected in the price, making bargain opportunities possible.
Moreover, the fact that there are inefficient markets in the world directly contradicts the efficient market theory, proving that some assets can be overvalued or undervalued, creating investment opportunities for excess gains.
Validity of the efficient market hypothesis
With several arguments and real-life proof that assets can become under- or overvalued, the efficient market hypothesis has some inconsistencies, and its validity has repeatedly been questioned.
While supporters argue that searching for undervalued stock opportunities using technical and fundamental analysis to predict trends is pointless, opponents have proven otherwise. Although academics have proof supporting the EMH, there’s also evidence that overturns it.
The EMH implies there are no chances for investors to beat the market, but for example, investing strategies like arbitrage trading or value investing rely on minor discrepancies between the listed prices and the actual value of the assets.
A prime example is Warren Buffet, one of the world’s wealthiest and most successful investors, who has consistently beaten the market over more extended periods through value investing approach, which by definition of EMH is unfeasible.
Another example is the stock market crash in 1987, when the Dow Jones Industrial Average (DJIA) fell over 20% on the same day, which shows that asset prices can significantly deviate from their values.
Moreover, the fact that active traders and active investing techniques exist also displays some evidence of inconsistencies and that a completely efficient market is, in reality, impossible.
Contrasting beliefs about the efficient market hypothesis
Although the EMH has been largely accepted as the cornerstone of modern financial theory, it is also controversial. The proponents of the EMH argue that those who outperform the market and generate an excess profit have managed to do so purely out of luck, that there is no skill involved, and that stocks can still, without a real cause or reason, outperform, whereas others underperform.
Moreover, it is necessary to consider that even new information takes time to take effect in prices, and in actual efficiency, prices should adjust immediately. If the EMH allows for these inefficiencies, it is a question of whether an absolute market efficiency, strong form efficiency, is at all possible. But as this theory implies, there is little room for beating the market, and believers can rely on returns from a passive index investing strategy.
Even though possible, proponents assume neither technical nor fundamental analysis can help predict trends and produce excess profits consistently, and theoretically, only inside information could result in outsized returns.
Moreover, several anomalies contradict the market efficiency, including the January anomaly, size anomaly, and winners-losers anomaly, but as usual, factual evidence both contradicts and supports these anomalies.
Parting opinions about the different versions of the EMH reflect in investors’ investing strategies. For example, supporters of the strong form efficiency might opt for passive investing strategies like buying index funds. In contrast, practitioners of the weak form of efficiency might leverage arbitrage trading to generate profits.
Marketing strategies in an efficient and inefficient market
On the one side, some academics and investors support Fama’s theory and most likely opt for passive investing strategies. On the other, some investors believe assets can become undervalued and try to use skill and analysis to outperform the market via active trading.
Passive investing
Passive investing is a buy-and-hold strategy where investors seek to generate stable gains over a more extended period as fewer complexities are involved, such as less time and tax spent compared to an actively managed portfolio.
People who believe in the efficient market hypothesis use passive investing techniques to create lower yet stable gains and use strategies with optimal gains through maximizing returns and minimizing risk.
Proponents of the EMH would use passive investing, for example:
- Invest in Index Funds;
- Invest in Exchange-traded Funds (ETFs).
However, it is important to note that other mutual funds also use active portfolio management intending to outperform indices, and passive investing strategies aren’t only for those who believe in the EMH.
Active investing
Active portfolio managers use research, analysis, skill, and experience to discover market inefficiencies to generate a higher profit over a shorter period and exceed the benchmark returns.
Generally, passive investing strategies generate returns in the long run, whereas active investing can generate higher returns in the short term.
Opponents of the EMH might use active investing techniques, for example:
- Arbitrage and speculation;
- Momentum investing ;
- Value investing .
The fact that these active trading strategies exist and have proven to generate above-market returns shows that prices don’t always reflect their market value.
For instance, if a technology company launches a new innovative product, it might not be immediately reflected in its stock price and have a delayed reaction in the market.
Suppose a trader has access to unpublished and private inside information. In that case, it will allow them to purchase stocks at a much lower value and sell for a profit after the announcement goes public, capitalizing on the speculated price movements.
Passive and active portfolio managers are often compared in terms of performance, e.g., investment returns, and research hasn’t fully concluded which one outperforms the other,
Efficient market examples
Investors and academics have divided opinions about the efficient market hypothesis, and there have been cases where this theory has been overturned and proven inaccurate, especially with strong form efficiency. However, proof from the real world has shown how financial information directly affects the prices of assets and securities, making the market more efficient.
For example, when the Sarbanes-Oxley Act in the United States, which required more financial transparency through quarterly reporting from publicly traded businesses, came into effect in 2002, it affected stock price volatility. Every time a company released its quarterly numbers, stock market prices were deemed more credible, reliable, and accurate, making markets more efficient.
Example of a semi-strong form efficient market hypothesis
Let’s assume that ‘stock X’ is trading at $40 per share and is about to release its quarterly financial results. In addition, there was some unofficial and unconfirmed information that the company has achieved impressive growth, which increased the stock price to $50 per share.
After the release of the actual results, the stock price decreased to $30 per share instead. So whereas the general talk before the official announcement made the stock price jump, the official news launch dropped it.
Only investors who had inside private information would have known to short-sell the stock , and the ones who followed the publicly available information would have bought it at a high price and incurred a loss.
What can make markets more efficient?
There are a few ways markets can become more efficient, and even though it is easy to prove the EMH has no solid base, there is some evidence its relevance is growing.
First , markets become more efficient when more people participate, buy and sell and engage, and bring more information to be incorporated into the stock prices. Moreover, as markets become more liquid, it brings arbitrage opportunities; arbitrageurs exploiting these inefficiencies will, in turn, contribute to a more efficient market.
Secondly , given the faster speed and availability of information and its quality, markets can become more efficient, thus reducing above-market return opportunities. A thoroughly efficient market, strong efficiency, is characterized by the complete and instant transmission of information.
To make this possible, there should be:
- Complete absence of human emotion in investing decisions;
- Universal access to high-speed pricing analysis systems;
- Universally accepted system for pricing stocks;
- All investors accept identical returns and losses.
The bottom line
At its core, market efficiency is the ability to incorporate all information in stock prices and provide the most accurate opportunities for investors; however, it isn’t easy to imagine a fully efficient market.
Research has shown that most developed capital markets fall into the semi-strong efficient category. However, whether or not stock markets can be fully efficient conclusively and to what degree continues to be a heated debate among academics and investors.
Disclaimer: The content on this site should not be considered investment advice. Investing is speculative. When investing, your capital is at risk.
FAQs on the efficient market hypothesis
The efficient market hypothesis (EMH) claims that prices of assets such as stocks are trading at accurate market prices, leaving no opportunities to generate outsized returns. As a result, nothing could give investors an edge to outperform the market, and assets can’t become under- or overvalued.
What are three forms of the efficient market hypothesis?
The efficient market hypothesis takes three forms: first, the purest form is strong form efficiency, which considers current and past information. The second form is semi-strong efficiency, which includes only current and past public, and not private, information. Finally, the third version is weak form efficiency, which claims stock prices always take a randomized path.
What contradicts the efficient market hypothesis?
The efficient market hypothesis directly contradicts the existence of investment strategies, and cases that have proved to generate excess gains are possible, for example, via approaches like value or momentum investing.
When more investors engage in the market by buying and selling, they also bring more information that can be incorporated into the stock prices and make them more accurate. Moreover, the faster movement of information and news nowadays increases accuracy and data quality, thus making markets more efficient.
Finance Digest
By subscribing you agree with Finbold T&C’s & Privacy Policy
Related guides
Are Election Years Good for the Stock Market? What Data Shows
Do Institutional Investors Beat the Market? Here's What Data Shows
Lessons from 2020: How Will the 2024 Election Affect the Stock Market?
What Institutional Investors Look for in IPOs—Tips for Retail Investors
Introducing price alerts.
Create price alerts for stocks & crypto. Get started
Disclaimer: The information on this website is for general informational and educational purposes only and does not constitute financial, legal, tax, or investment advice. This site does not make any financial promotions, and all content is strictly informational. By using this site, you agree to our full disclaimer and terms of use. For more information, please read our complete Global Disclaimer .
IMAGES
VIDEO
COMMENTS
The efficient market hypothesis (EMH), alternatively known as the efficient market theory, is a hypothesis that states that share prices reflect all available information and consistent alphage…
The efficient market hypothesis argues that current stock prices reflect all existing available information, making them fairly valued as they are presently.
The Efficient Market Hypothesis (EMH) is a theory suggesting that financial markets are perfectly efficient, meaning that all securities are fairly priced as their prices reflect all available public information.
The efficient-market hypothesis (EMH) is a hypothesis in financial economics that states that asset prices reflect all available information. A direct implication is that it is impossible to "beat the market" consistently on a risk-adjusted basis since market prices should only react to new information. Because the EMH is formulated in terms of risk adjustment, it only makes test…
The efficient-market hypothesis says that financial markets are effective in processing and reflecting all available information with little or no waste, making it impossible for investors to consistently outperform the market based …
The efficient market hypothesis (EMH) claims that all assets are always fairly and accurately priced and trade at their fair market value on exchanges. If this theory is true, nothing can give you an edge to outperform …
The efficient market hypothesis (EMH) theorizes that the market is generally efficient, but offers three forms of market efficiency: weak, semi-strong, and strong.