What Is Efficient Market Hypothesis (EMH)?

The Efficient Market Hypothesis (EMH) has become an essential concept in financial theory since its introduction by Eugene Fama in the 1960s. According to this theory, financial markets are so efficient that all available information has already been factored into stock prices. Hence, it makes it impossible for individual investors to outperform market returns consistently.

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Assumptions of EMH

• Investors may act rationally or normally. When faced with unusual information, an investor might respond differently than expected or behave like everyone else. Both these situations indicate normal behavior.
• Stock prices provide investors with all relevant market data.
• It also assumes that investors cannot exploit the market, since they must act based on market information when making decisions and acting accordingly.

What are the three forms of EMH?

• Weak Form Efficient Market Hypothesis

According to this interpretation of EMH, all past trading information, such as stock prices and volumes, has already been factored into current stock prices, eliminating any chance for technical analysis (analysing past price movements) to provide an edge.

• Semi-strong Efficient Market Hypothesis

This approach further asserts that all publicly available information, historical data, and all public knowledge are already reflected in stock prices. Hence, neither fundamental analysis (assessing a company's financial health and prospects) nor insider knowledge can provide any advantage over competitors.

• Strong Form Efficiency

EMH's most extreme version posits that all information, even insider information, has already been priced in stocks. Therefore, no investor can consistently outwit the market, even those with access to exclusive data.

Critiques of EMH

EMH remains highly esteemed but has come under criticism, and a few of them are:

• Behavioural Finance

Critics argue that EMH fails to consider behavioral biases and irrationality among investors, which may contribute to market inefficiency.

• Market Anomalies

Market anomalies occur when there is an inconsistent relationship between market prices as established by an efficient market hypothesis and their actual behaviour in real life. Anomalies may arise at any moment and for no apparent reason, demonstrating that financial markets don't always remain efficient.

• Market Crashes & Speculative Bubbles

Speculative bubbles arise when the price of a financial instrument increases beyond its fair market value and reaches a point at which market corrections begin taking place. Once reached, prices fall rapidly before eventually leading to a market crash. However, according to EMH theory, financial crashes and market bubbles should never happen and the theory denies their very existence.

To conclude

Believing in the efficient market hypothesis calls into question the strategies employed by active investors. If markets truly are efficient, investment companies shouldn't overspend by overcompensating fund managers. Whether you believe in the efficiency of markets or not, it's essential to stay informed, adapt to changing conditions, and be cautious.

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