What is the Efficient Market Hypothesis?

In finance, the efficient market hypothesis (EMH) asserts that financial markets are “efficient”, or that the current price of a share reflects everything that is known about the company and its future earnings potential, and is, therefore, accurate in the sense that it reflects the collective beliefs of all investors about future prospects.

EMH suggests that the army of analysts and fund managers whose job is to actively manage portfolios are engaged in a futile exercise because everything they find out is rapidly transmitted around the market, and share prices instantly reflect the common knowledge. In other words, no one can get one up on anyone else. And the logical extension of this is that passive funds – tracker and index funds – are the best place to park your money, because their management costs are much lower and they are mathematically structured to match the performance of their chosen index.

It is a common misconception that EMH requires that investors behave rationally. This is not in fact the case. EMH allows that when faced with new information, some investors may overreact and some may underreact. All that is required by the EMH is that investors’ reactions be random enough that the net effect on market prices cannot be reliably exploited to make an abnormal profit. Under EMH, the market may, in fact, behave irrationally for a long period of time. Crashes, bubbles and depressions are all consistent with efficient market hypothesis, so long as this irrational behavior is not predictable or exploitable.

There are three common forms in which the efficient market hypothesis is commonly stated – weak form efficiency, semi-strong form efficiency and strong form efficiency, each of which have different implications for how markets work.

1. The “Weak” form asserts that all past market prices and data are fully reflected in securities prices. Weak-form efficiency implies that no Technical analysis techniques will be able to consistently produce excess returns.

2. The “Semistrong” form asserts that all publicly available information is fully reflected in securities prices. Semi-strong-form efficiency implies that Fundamental analysis techniques will not be able to reliably produce excess returns.

3. The “Strong” form asserts that all information is fully reflected in securities prices. In other words, no one will be able to consistently produce excess returns.

Though fund managers have consistently beaten the market, this does not necessarily invalidate strong-form efficiency. You need to consider how many managers in fact do beat the market, how many match it, and how many underperform it. The results imply that performance relative to the market is more or less normally distributed, so that a certain percentage of managers can be expected to beat the market. Given that there are tens of thousand of fund managers worldwide, then having a few dozen star performers is perfectly consistent with statistical expectations.

Securities markets are flooded with thousands of well-educated investors seeking under and over-valued securities to buy and sell. The more participants and the faster the dissemination of information, the more efficient a market should be.

The paradox of efficient markets is that if every investor believed a market was efficient, then the market would not be efficient because no one would analyze securities. In effect, efficient markets depend on market participants who believe the market is inefficient and trade securities in an attempt to outperform the market.

The debate about efficient markets has resulted in hundreds and thousands of empirical studies attempting to determine whether specific markets are in fact “efficient” and if so to what degree.

In reality, markets are neither perfectly efficient nor completely inefficient. Government bond markets for instance, are considered to be extremely efficient. Most researchers consider large capitalization stocks to also be very efficient, while small capitalization stocks and international stocks are considered by some to be less efficient.

The efficient market debate plays an important role in the decision between active and passive investing. Active managers argue that less efficient markets provide the opportunity for outperformance by skillful managers. However, its important to realize that a majority of active managers in a given market will underperform the appropriate benchmark in the long run whether markets are or are not efficient. This is because active management is a zero-sum game in which the only way a participant can profit is for another less fortunate active participant to lose. However, as I’ve discussed before, when costs are added, even marginally successful active managers may underperform.