What is the Efficient Market Hypothesis?
The Efficient Market Hypothesis (EMH) is one of the main reasons why some investors might choose a passive investment strategy. It helps explain the rationale for buying passive mutual funds and exchange-traded funds (ETFs).
What are the types of EMH?
There are three forms of EMH: weak, semi-strong, and strong. Here’s what each type says about the market:
Weak form of EMH: The weak form of EMH suggests that all past information is already priced into securities. Security analysis may provide information that can help you achieve returns that exceed the average market return in the short term. However, there are no “patterns.” Therefore, fundamental analysis does not provide a long-term advantage, nor does technical analysis.
Semi-strong form of EMH: The semi-strong form of EMH indicates that both fundamental analysis and technical analysis cannot provide you with an advantage. It also suggests that new information is immediately priced into securities.
Strong form of EMH: The strong form of EMH states that all information, whether public or private, is priced into stocks. Therefore, no investor can achieve an advantage over the market as a whole. The strong form of EMH does not claim that it is impossible to achieve abnormally high returns. This is because there are always abnormal values included within the averages.
EMH does not say you can never beat the market. It says that there are abnormal values that can outperform market averages. But there are also abnormal values that lag far behind the market. Most are closer to the mean. Those who “win” are lucky; those who “lose” are unlucky.
EMH and Investment Strategies
Proponents of EMH, even in its weak form, often invest in index funds or some ETFs. This is because those funds are passively managed and simply aim to match overall market returns, not beat them.
Investors in index funds may follow the common saying: “If you can’t beat them, join them.” Instead of trying to outperform the market, they will buy an index fund that invests in the same securities as the benchmark index.
Some investors may attempt to beat the market, believing that stock price movements can be predicted, at least to some extent. For this reason, EMH does not align with day trading strategies. Traders study trends and patterns in the short term and then try to figure out when to buy and sell based on these patterns. Day traders would dispute the strong form of EMH.
Tip: For more information on EMH, including arguments against it, you can check the EMH paper by economist Burton G. Malkiel. Malkiel is also the author of the investment book “A Random Walk Down Wall Street.” The random walk theory says that stock price movements are random.
Conclusion
If you believe you cannot predict stock market movements, you are likely to support EMH most of the time. However, a short-term trader may reject the ideas posed by EMH because they believe they can predict stock price changes.
For most investors, a long-term passive investment strategy is beneficial. Financial markets are often unpredictable with random price movements.
Frequently Asked Questions (FAQs)
When did the Efficient Market Hypothesis first emerge?
At the core of EMH is the idea that, in general, even professional traders are unable to outperform the market in the long term using fundamental or technical analysis. This idea has roots in the 19th century and the “random walk” theory of stocks. The title EMH is sometimes attributed to Eugene Fama’s 1970 paper “Efficient Capital Markets: A Review of Theory and Empirical Work.”
How
Is the Efficient Market Hypothesis used in the real world?
Investors who use the EMH in their real portfolios are likely to make fewer decisions than those who use fundamental analysis or technical analysis. They are more likely to invest simply in broad market products, such as the S&P 500 and total market funds.
Source: https://www.thebalancemoney.com/efficient-markets-hypothesis-emh-2466619
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