Investors who try to time the market usually do so because they believe that stocks aren’t trading at their true value. The efficient market hypothesis is contradictory to this idea, stating that all share prices reflect their fair market value. In other words, the efficient market hypothesis states that stock prices have already factored in all available information. This hypothesis is one that can significantly impact one’s investing strategies since the premise of the theory is that it’s impossible to beat the market.
What is the Efficient Market Hypothesis?
The efficient market hypothesis emanates from a body of work called “Efficient Capital Markets: A Review of Theory and Empirical Work,” by Eugene Fama. The Nobel laureate in economic sciences is widely recognized as the “father of modern finance”.
The basis of the theory is that engaging in investing strategies like hand picking undervalued stocks or trying to predict market trends using technical analysis is a waste of time. That said, there are several counter arguments for the efficient market hypothesis, some of which come from investors who have successfully beaten the market. The existence of asset bubbles suggests that stocks can be inaccurately valued.
The EMH, however, does take market volatility into consideration. As a result, the hypothesis lobbies for investing in low-cost and passive portfolios. Examples of passive investing strategies may include low-cost index funds or ETFs.
Volatility in the market is sometimes a result of a lack of information provided by companies. If there are fewer surprises when companies release financial reports, it could mean more stable security prices.
Types of Efficient Market Hypothesis
There are three variations or forms of the efficient market hypothesis and they’re all similar with slight nuances. They include weak, strong, and semi-strong forms.
Strong Efficient Market Hypothesis
Followers of the strong form of efficient market hypothesis believe current security prices encompass all past, public, and private information. If this were true, it would mean even investors with inside information couldn’t beat the market or tap into higher-than-average returns.
Weak Efficient Market Hypothesis
The weak form believes security prices only reflect past information and don’t reflect new or private information that hasn’t been released to the public. This contrasts from the strong efficient market hypothesis, which believes prices are indeed based on all available information. Weak form also believes past prices don’t have an influence on future ones, so technical analysis is useless, meaning analyzing past performance won’t help predict future performance.
Investors who believe in the weak form believe fundamental analysis and financial statements can be used to identify undervalued and overvalued stocks.
Semi-Strong Efficient Market Hypothesis
Semi-strong form believers think market prices reflect past information and publicly available information. It infers that any new information that props up impacts market prices. The theory looks at how the market price of securities fluctuates as new information becomes available. On this basis, only information that is inaccessible to the public can help give investors an advantage that could lead to them beating the market.
Efficient Market Hypothesis and Investing
Investors who are believers of the efficient market hypothesis tend to gravitate towards passive investing since the fundamental belief is that you can’t beat the market. More specifically, investors may opt for index funds or index strategies.
That said, since it’s been proven that it is possible to beat the market, some of the funds are actively managed with the objective of outperforming a benchmark index. Investors looking to make above-average returns often need the right experience and analytical skills to find success on that mission. Even among financial professionals, beating the market over time is rare and involves a healthy dose of luck.
