efficient market hypothesis definition in economics

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EMH and Passive Investing

Market inefficiencies, the bottom line, efficient market hypothesis (emh): definition and critique.

Gordon Scott has been an active investor and technical analyst or 20+ years. He is a Chartered Market Technician (CMT).

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 available 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 . The only way an investor can obtain higher returns is by purchasing riskier investments.

Key Takeaways

• The efficient market hypothesis (EMH) or theory states that share prices reflect all the information available.
• According to the EMH, stocks trade at their fair market value on exchanges.
• Proponents of EMH posit that investors benefit from investing in a low-cost, passive portfolio.
• Opponents of EMH believe that it is possible to beat the market and that stocks can deviate from their fair market values.

Investopedia / Theresa Chiechi

Understanding the Efficient Market Hypothesis (EMH)

Although it is a cornerstone of modern financial theory, the EMH is highly controversial and often disputed.

Proponents of EMH argue it is pointless to search for undervalued stocks or to try to predict trends in the market through either fundamental or technical analysis . Because stock prices reflect all available information, and because of the randomness of the market, the best investing strategy is a low-cost, passive portfolio.

Theoretically, neither technical nor fundamental analysis can produce risk-adjusted excess returns (alpha) consistently, and only inside information can result in outsized risk-adjusted returns.

$676,597.44

The October 3, 2024 share price of the most expensive stock in the world: Berkshire Hathaway Inc. Class A (BRK.A).

While academics point to a large body of evidence in support of EMH, an equal amount of dissension also exists. For example, investors such as Warren Buffett have consistently beaten the market over long periods, which by definition is impossible according to the EMH.

Detractors of the EMH also point to events such as the 1987 stock market crash, when the Dow Jones Industrial Average (DJIA) fell by over 20% in a single day, and asset bubbles as evidence that stock prices can seriously deviate from their fair values.

The assumption that markets are efficient is a cornerstone of modern financial economics—one that has come under question in practice.

The EMH argues for a passive investing strategy, rather than an active one, in which investors buy and hold a low-cost portfolio over the long term to achieve the best returns.

Data compiled by Morningstar Inc., in its 2024 Active/Passive Barometer study showed that actively managed funds can outperform passive ones: from 2023 to 2024, 51% of active funds outperformed passive funds. Better success rates were found in bond funds, while active foreign equity funds and large-cap funds underperformed passive funds in these categories. However, active funds' long-term performance is still generally below that of passive funds. The 2019 version of the same study found that, from 2009 to 2019, only 23% of active managers were able to outperform their passive peers. In general, investors have fared better by investing in low-cost index funds or ETFs.

While a percentage of active managers do outperform passive funds at some point, the challenge for investors is being able to identify which ones will do so over the long term. As shown in the 2019 report, less than 25% of the top-performing active managers can consistently outperform their passive manager counterparts over time.

The EMH proposes that markets are efficient. However, there are some markets that are demonstrably 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. In reality, most markets do display some level of inefficiencies. In extreme cases, 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 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.

How Valid Is the Efficient Markets Hypothesis?

The validity of the EMH has been questioned on both theoretical and empirical grounds. Some investors have beaten the market, such as  Warren Buffett , whose investment strategy of focusing on  undervalued  stocks has made billions and set an example for numerous followers. There are portfolio managers who have better track records than others, and there are investment houses with more renowned research analysis than others. EMH proponents, however, argue that those who outperform the market do so not out of skill but out of luck, due to the laws of probability: at any given time in a market with a large number of actors, some will outperform the mean, while others will  underperform .

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.

The efficient market hypothesis (EMH), also known as the efficient market theory, posits that markets are efficient, meaning share prices reflect all available information, both public and private. This means that stocks trade at their fair value, so most investors will see the best results from holding a low-cost, passive portfolio over the long term.

Opponents of EMH believe that it is possible to beat the market and that stocks can deviate from their fair market values. This has been demonstrated by investors such as Warren Buffet, whose strategy of investing in undervalued stocks has earned billions. Like many economic theories, the EMH cannot fully reflect real-world conditions. However, research has found that its conclusions are generally correct: a low-cost, passive portfolio will, on average, achieve the best long-term results for most investors.

The Library of Economics and Liberty. " Efficient Capital Markets ."

Yahoo Finance. " Berkshire Hathaway Inc. (BRK-A) ."

Federal Reserve History. " Stock Market Crash of 1987 ."

Morningstar. " US Active/Passive Barometer Report: Mid-Year 2024 ."

Morningstar. " The Morningstar Active/Passive Barometer Might Help Investors Improve Their Base Rates ."

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Efficient Market Hypothesis

Definition of Efficient Market Hypothesis It is the idea that the price of stocks and financial securities reflects all available information about them. If new information about a company becomes available, the price will quickly change to reflect this.

Three Types of Efficient market hypothesis

• Weak EMH. This states all past market prices and data are fully reflected in the price of securities and stocks.  However, some information about events shaping the company may not be fully reflected in the price. In other words, technical analysis of prices is of no use.
• Semistrong EMH. This states asserts that all publicly available information is fully reflected in securities prices. In other words, fundamental analysis is of no use.
• Strong Form of EMH asserts that all information is fully reflected in securities prices. In other words, even insider information is of no use.

The Efficient Market hypothesis requires certain assumptions.

• Many buyers and sellers
• Agents have rational expectations and on average make good decisions about buying shares/stocks
• Perfect information about market trends and profit of firms.

Implications of the Efficient Market Hypothesis

• Markets are efficient in determining the prices of financial securities.
• Investors tend to be rational.
• It is not possible (except through luck) to outperform the market.
• Prices may not determine future stock performance e.g. the market may not know about an event which will lead to lower profit.
• It is easy to buy and sell. For example, housing markets are less close to the model of efficient market hypothesis because there are significant time lags in buying selling and stamp duty e.t.c.

If we assume an efficient market hypothesis it suggests regulators need to do little, if anything to prevent asset/stock market bubbles. Because according to this theory, irrational asset price bubbles shouldn’t occur. However, if the efficient market hypothesis is not true, then there is a greater role for regulators to intervene in asset/stock bubbles to prevent a boom and bust. (assuming regulators don’t get caught up in the same irrational exuberance as investors)

If some investors ignore data and get caught up in bubbles, then in theory ‘efficient investors’ should be able to profit by ‘shorting’ a boom. (see: short selling explained ) But as Keynes said, the market can remain irrational for longer than you can remain solvent. In other words, a bubble may last for a long time and your short positions may fail before you finally benefit from the collapse in prices.

Criticisms of the efficient market hypothesis

Stock Prices often reflect evidence of:

• Irrational exuberance – people getting carried away by booms and asset bubbles (e.g. US house prices in the 2000s, Dot Com Bubble and Bust.
• Behavioural economics places greater emphasis on the irrationality of human behaviour in making economic decisions e.g. herding effect e.t.c

Empirical evidence that stock prices do not reflect. E.g. According to Dreman, in a 1995 paper, low P/E stocks have greater returns.

Even the founder of EMH, Eugene Fama found in a 1990s study that many stocks didn’t follow a random walk model but that ‘value’ stocks outperformed. They also found a ‘momentum effect’ where stocks which had done well in the past, often continued to do well in the future. Fama tried to defend his theory by saying cheap stocks had a greater risk.

Joseph Stiglitz published a proof saying that if the efficient market hypothesis was true it would be logically irrational to spend money on research – which people clearly do.

6 thoughts on “Efficient Market Hypothesis”

how do individuals make profit in an efficient market

It is totally possible to make profit because markets are NOT efficient…

efficient market does not mean you dont make a profit.You make risk-adjusted profits,however you can not make abnormal profits because prices follow random paths and are unpredictable.Best ways to say it is that you can not make abnormal profits consistently.

I have a an economics question I need help with. List 5 markets that are efficient and tell why you believe that are. List 5 markets that are inefficient and tell why you believe they are. HELP!!!

List 5 markets that you feel are efficient and tell why you think they are efficient. List 5 markets that you feel are inefficient and tell me why you think they are inefficient.

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