EMH

Efficient Market Hypothesis (EMH)

What Is the Efficient Market Hypothesis (EMH)?

The efficient market hypothesis (EMH), alternatively known as the efficient market theory, is a hypothesis that states that share prices reflect all information and consistent alpha generation is impossible. According to the EMH, stocks always trade at their fair value on exchanges, making it impossible for investors to purchase undervalued stocks or sell stocks for inflated prices. Therefore, it should be impossible to outperform the overall market through expert stock selection or market timing, and the only way an investor can obtain higher returns is by purchasing riskier investments. 

What Does It Mean for Markets to Be Efficient?

Market efficiency refers to how well prices reflect all available information. The efficient markets hypothesis (EMH) argues that markets are efficient, leaving no room to make excess profits by investing since everything is already fairly and accurately priced. This implies that there is little hope of beating the market, although you can match market returns through passive index investing. 

Can Markets Be Inefficient?

There are certainly some markets that are less efficient than others. An inefficient market is one in which an asset’s prices do not accurately reflect its true value, which may occur for several reasons. Market inefficiencies may exist due to information asymmetries, a lack of buyers and sellers (i.e. low liquidity), high transaction costs or delays, market psychology, and human emotion, among other reasons. Inefficiencies often lead to deadweight losses. Most markets do display some level of inefficiencies, and in the extreme case an inefficient market can be an example of a market failure.

Accepting the EMH in its purest (strong) form may be difficult as it states that all information in a market, whether public or private, is accounted for in a stock’s price. However, modifications of EMH exist to reflect the degree to which it can be applied to markets:

Semi-strong efficiency – This form of EMH implies all public (but not non-public) information is calculated into a stock’s current share price. Neither fundamental nor technical analysis can be used to achieve superior gains.

Weak efficiency – This type of EMH claims that all past prices of a stock are reflected in today’s stock price. Therefore, technical analysis cannot be used to predict and beat the market.

What Can Make a Market More Efficient?

The more participants are engaged in a market, the more efficient it will become as more people compete and bring more and different types of information to bear on the price. As markets become more active and liquid, arbitrageurs will also emerge, profiting by correcting small inefficiencies whenever they might arise and quickly restoring efficiency.