Efficient Market Hypothesis (EMH): Definition, History, How it Works and Forms

Efficient Market Hypothesis (EMH) Definition
Efficient Market Hypothesis (EMH) Definition, History, How it Works & Forms

The Efficient Market Hypothesis (EMH) is an investment theory that states that share prices reflect all the available market information. The Efficient Market Hypothesis is also known as the Efficient Market Theory, and it was put forward by Eugene Fama, an American economist. The EMH posits that since asset prices reflect all information, no investor can have a winning edge over another through stock analysis and market timing strategies. Furthermore, it assumes that all stocks always trade at their fair market price. Hence, according to the EMH, investors cannot make profits through undervalued stocks. 

EMH  traces its origins to Eugene Fama’s Efficient Capital Markets: A Review of Theory and Empirical Work. In this work, Fama explained his ideas of an “informationally efficient” market, which forms the basis of the EMH. According to Fama’s hypothesis, it is impossible to outperform the market, and it is only by taking high risks that an investor can get high returns.

EMH works on the hypothesis that consistently producing excess returns is impossible.It hypothesizes that trading strategies involving the trade of undervalued stocks and the prediction of market trends using technical and fundamental analysis are of no use to investors. Depending on the market efficiency levels, EMH is classified into three categories, namely, weak form, semi-strong form, and strong form market hypothesis. Each category represents a different market efficiency level. 

What is the Efficient Market Hypothesis (EMH)?

The Efficient Market Hypothesis (EMH) is a financial theory that argues that all market information concerning share prices is freely available to all market participants. The EMH evolved from the theory that a market is always informationally efficient. It posits that all shares trade at fair market value on exchanges. The EMH implies that outperforming the market is impossible through stock analysis and market timing strategies. According to this hypothesis, alpha generation is also not possible on a consistent basis. Alpha refers to the term used to measure an asset’s ability to outperform the market. Alpha, in simple terms, refers to the returns received over the set benchmark returns and are also known as excess returns. 

The EMH is one of the foundational theories of modern financial studies. The significance of the EMH lies in its assumption that investors can make high returns only by taking high risks. The EMH presumes investors cannot outperform the market by trading undervalued stocks or selling a stock at inflated prices, as all investors trade based on the same information. The EMH disregards all technical and fundamental analyses that attempt to predict stock prices.  Instead, proponents of the EMH believe in investing in passive portfolios and opt for passive investment strategies, which are also low-cost. 

What is the Theoretical Background of the Efficient Market Hypothesis (EMH)?

The theoretical background of EMH is based on several recent and older books. The Efficient Market Hypothesis and its Application to Stock Markets Paperback by Sebastian Harder is an example. It is a research Paper (undergraduate level) from the year 2008. the paper examines the relationship between the stock market and the real estate market in the United States. Especially during the decade of the 1990s, a period in which the stock markets increased substantially, a large number of individual investors entered the stock market. They were enticed by exceptional returns and ignored the possibility of incurring losses. Before the Financial Crisis became a reality, the same tendency could be seen. However, any endlessly rising stock market will eventually collapse because stock values are based only on relevant news and are determined in a random fashion. Rapid readjustment to the new information occurs. The Efficient Market Hypothesis (EMH) will be assessed in this study, and the following is the EMH’s theoretical justification, which will be evaluated. The author provides a summary of the EMH by elaborating on its fundamental concepts and the mathematical representation of those ideas. During the application phase, the EMH was reviewed based on a number of specific cases; nonetheless, the theory could only be partially accepted.

What is the history of the Efficient Market Hypothesis? 

The Efficient Market Hypothesis traces its roots back to Eugene Fama’s groundbreaking research on market efficiency. Eugene Fama is a Nobel laureate and professor at the University of Chicago.  In 1970, he proposed an “informationally efficient” market in his book, Efficient Capital Markets: A Review of Theory and Empirical Work. Today, Fama is considered the father of modern finance, and his Efficient Market Theory has become the foundation of modern financial theory. 

A Scottish botanist named Robert Brown in 1828 first noted that pollen grains floating in water oscillated rapidly when examined via a microscope (Brown, 1828). Then, in 1863, a French stockbroker named Jules Regnault noticed that price fluctuations might provide greater gains or losses the longer an investor holds a securities; specifically, that the price deviation is related to the square root of the holding period (Regnault, 1863). In 1880, a British scientist named Lord

Due to his research into the effects of sound vibrations, Rayleigh was familiar with the concept of a random walk (Rayleigh, 1880). Despite the fact that John Venn, a British logician and philosopher, had a firm grasp of the concepts of a random walk and Brownian motion by the year 1888, (Venn, 1888). In his book The Stock Markets of London, Paris, and New York (1889), George Gibson made unambiguous reference to efficient markets. When “shares become publicly recognized in an open market,” Gibson argued, “the value which they gain may be considered as the judgment of the finest intelligence respecting them” (Gibson, 1889). Fundamental Economic Principles was published the next year by Alfred Marshall (Marshall, 1890).

Louis Bachelier, a French mathematician, completed his doctoral dissertation, Theorie de la Sp’eculation ‘, in 1900 (Bachelier, 1900). Five years before Einstein, he figured out the algebra and statistics of Brownian motion (1905). The author also arrived at the conclusion that “the speculator has no mathematical expectation.” Before Samuelson (1965) used a martingale to describe efficient markets, the concept had been around for 65 years. Bachelier’s work was ahead of its time, so nobody paid attention to it until Savage found it again in 1955. Professor and Royal Society Fellow Karl Pearson coined the phrase “random walk” in the letters section of Nature five years later (Pearson, 1905). After developing the equations for Brownian motion, Albert Einstein did not know about Bachelier’s work from 1900. (Einstein, 1905). Marian Smoluchowski, a Polish physicist, first characterized Brownian motion the next year (von Smoluchowski, 1906). Andre Barriol’s work on financial transactions contains some of the same ideas made by Bachelier (Barriol, 1908). De Montessus’published a book on probability and its applications in the same year as Bachelier’s thesis (de Montessus, 1908), which includes a chapter on finance. Meanwhile, Langevin established the Brownian motion stochastic differential equation (Langevin, 1908).

George Binney Dibblee wrote The Laws of Supply and Demand in 1912. (Dibblee, 1912). Over six thousand copies of Bachelier’s 1914 book, “Le Jeu, la Chance et le Hasard” (The Game, the Chance, and the Hazard), were sold in its first two years of publication. Price-change distributions are supposedly too “peaked” to be comparable to samples from Gaussian populations, a fact originally noticed by Wesley C. Mitchell, as reported by Benoit Mandelbrot (Mandelbrot, 1963). (Mitchell, 1915).

F. W. Taussig wrote an article titled “Is market pricing determinate?” that was published. (Taussig, 1921) John Maynard Keynes, an English economist, made it apparent in 1923 that a direct consequence of the EMH is that investors in financial markets are rewarded not for knowing better than the market what the future holds, but rather for risk bearing (Keynes, 1923). When comparing stock market swings to the probability curve you’d get from rolling dice, economist Frederick MacCauley found some remarkable similarities (MacCauley, 1925).

In his Paris PhD dissertation, Maurice Olivier provided indisputable evidence of the leptokurtic character of the distribution of returns (Olivier, 1926). Frederick C. Mills established the leptokurtosis of returns in The Behavior of Prices (Mills, 1927). Given its magnitude and length, the Wall Street Catastrophe of late October 1929 was the worst stock market crash in American history.

How does the Efficient Market Hypothesis (EMH) work in the stock market?

The Efficient Market Hypothesis works on the assumption that all relevant market information regarding the price of a financial instrument is available to all market participants. Therefore, the EMH considers all stocks to trade at their fair market price. The fair market price is the price an asset would sell for in the market when buyers and sellers make purchase decisions in their interests, without any outward pressure.

Efficient Market Hypothesis (EMH) work in the stock market
Efficient Market Hypothesis (EMH) in the stock market

The EMH functions on the assumption that since all assets trade at their fair price, there’s no possibility of an asset being under or overvalued. As a result, no investor can have a cutting edge over another by predicting market prices or using market timing strategies. Instead, all the proponents of the EMH invest in passive portfolios that perform according to the benchmark performance. 

Although a highly critiqued theory, the EMH is gradually gaining popularity among traders. Traders and stockbrokers who are proponents of the EMH invest in passive funds such as index funds and Exchange Traded Funds (ETFs). Traders use the EMH mainly to avoid the high expense ratio associated with more actively managed funds. Actively managed funds incur high charges in terms of fees for experienced fund managers. In addition, since the underlying belief behind EMH advocates that it is impossible to outperform the stock market with stock analysis or strategies, the proponents of the EMH don’t have to rely on expert fund managers for their returns. 

What does Efficient Market Hypothesis (EMH) say about stock prices in Stock Market?

According to the efficient market theory, any new information that enters the market is quickly reflected in stock prices. As a result, neither fundamental nor technical research can yield excess profits. The author evaluates current research that appears to refute the theory and finds that it relates to behavioral finance, momentum investing, and popular fundamental ratios. After doing so, the author comes to the conclusion that this research is not relevant in the long term. Therefore, in his opinion, the concept of an efficient market continues to hold true.

What are the three forms of the Effective Market Hypothesis? 

The Effective Market Hypothesis has three forms, each representing varying degrees of market efficiency.

forms of the Effective Market Hypothesis
3 Forms of the Effective Market Hypothesis

The three forms of the Effective Market Hypothesis are listed below. 

1. Weak Form 

The weak form of the EMH posits that while asset prices reflect all relevant market information, the prices may not reflect new information that has not been publicized. The weak form of EMH also believes that historical prices cannot influence future prices. The weak form, thus, disregards all forms of technical analysis as technical analysis draws historical data to predict future prices. However, the weak form of the EMH does take into account the possibilities of fundamental analysis.  

2. Strong Form 

The strong form of the EMH posits that an asset’s price reflects all information, including private and public. The strong form of the EMH argues that the information mirrored by an asset’s price includes current information, historical information, insider information, and information that is available only to the company’s board of directors. The strong form thus dismisses both technical and fundament analysis. Its stance argues that not even insider information can give an investor a winning edge over others. 

3. Semi-Strong Form

The semi-strong form builds on the weak form of the EMH. The semi-strong form argues that asset prices reflect any new market information rapidly. The semi-strong form, therefore, dismisses the scope for fundamental analysis, which the weak form entertains. Like the strong form, the semi-strong form does not consider fundamental and technical stock analysis. 

The Efficient Market Hypothesis has investors and traders on either side of it. While its proponents have faith in its advantages, it is critiqued by others who draw attention to its disadvantages. Investors and stock traders also criticize the EMH over the anomalies it poses. 

What are the Advantages of the Efficient Market Hypothesis (EMH) in the stock market?

The three main advantages of the Efficient Market Hypothesis are listed below. 

  1. It gives equal opportunities to all investors. 

One of the main advantages of the EMH is that it gives both new and experienced investors equal opportunities to make returns. Since the EMH dismisses all technical and fundamental stock analysis, no investor can have an advantage over another using their knowledge or experience. The EMH argues that all investors have the same ability to make money through the stock market. Regardless of the investor’s ability to access insider or other information, the EMH posits that the asset price reflects all the relevant information. 

  1. It gives insight into how market prices are determined

The second key advantage of the EMH is that it gives insight into how the market prices are set. According to the EMH, the market prices of assets are set by taking into all the relevant information, including insider information and information that is only be available to the company’s board of directors. 

  1. It gives investors a low-cost investment option. 

Another advantage of the EMH is that it advocates low-cost, passive investment options. The underlying belief of the EMH is that no investor or fund manager can outperform the market through stock analysis or market timing strategies. Thus, investors can reduce the high expense ratio and charges that most experienced fund managers demand. 

What are the Disadvantages of the Efficient Market Hypothesis (EMH) in the stock market? 

The two main disadvantages of the Efficient Market Hypothesis are listed below. 

  1. It fails to explain the market volatility. 

One of the primary disadvantages of the EMH is that it does not explain market volatility. Market Volatility refers to the rate at which the market prices fluctuate. The EMH fails to explain how or what information causes the market prices to change. Moreover, the prices would get adjusted automatically, and there would be no market crashes or bubbles if the market were efficient. 

  1. It assumes that all investors process the available information in the same way. 

Another disadvantage of the EMH is that it assumes that all investors process information similarly. Not all investors have the same amount of time to spend on market news. The manner in which they process the available information also differ from investor to investor. 

What are the criticisms of the Efficient Market Hypothesis (EMH)?

Technical and fundamental analysts are the main criticizers of EMH. Let us look four of the common criticisms.

1. EMH anomalies and rejection of the Capital Asset Pricing Model (CAPM)

The CAPM looks at the level of risk involved and attempts to calculate an appropriate return. When making investing choices, the model is often used in combination with fundamental research, technical analysis, and other approaches to assessing assets. However, many experts in the field of finance caution that CAPM shouldn’t be used to determine the anticipated return of equity shares since it doesn’t take into account the market’s actual volatility. Let’s dissect the method and think about whether or not it should be used by investors to gauge the potential danger of a certain financial commitment.

When trying to determine whether a stock is priced fairly, many investors turn to the Capital Asset Pricing Model (CAPM). Therefore, the method will be used to re-determine pricing and forecasting for projected returns if the amount of risk changes or other market circumstances make an investment riskier.

When interest rates shift, for instance, it’s usual practise to reevaluate pricing and returns. As this piece is being written in March of 2021, rising interest rates are a major issue for investors.

Changes in interest rates, either up or down, might affect how costly or affordable it is to take out a loan. And this, in turn, will have knock-on effects on the stock market and investors’ expected returns.

Assuming rates continue to rise, the cost of borrowing money will rise, which might reduce a firm’s earnings and cash flow. Additionally, investors may demand a higher rate of return in exchange for taking on greater risk in the company.

The value of a company’s stock will drop as a result or rise as interest rates fall, provided the opposite ripple effect holds true. In any instance, it’s a good idea to reevaluate the stock’s fair value to see whether it’s still worth the risk.

2. Late 2000s financial crisis

U.S. and European economies were hit particularly hard by the global financial crisis of 2008–2009. The unemployment rate climbed into the double digits and then some, and both the European and American economies are still performing much below their potential. In addition, the large levels of consumer, financial institutions, and government debt have rendered the severe recession extremely lengthy and stifled the fiscal policy responses of governments throughout the globe.

Modern financial theory, which assumed that our financial systems were most efficient, has likewise been shaken to its core by the crisis. Obituaries for the “efficient market hypothesis,” or EMH, as it was often abbreviated, were prepared by financial journalists and economists alike. In 2010, financial author Justin Fox released a bestseller titled The Myth of the Rational Market. EMH was called “the most astonishing blunder in the history of economic theory” by economist Robert Shiller. It became even more extreme among some expert fund managers. Jeremy Grantham blamed EMH for the financial crisis and said it was “more or less directly accountable.” The confidence in efficient financial markets “blinded many if not most economists to the formation of the largest financial bubble in history,” Paul Krugman (2009) 4concurred. Even efficient-market theories contributed to the bubble’s initial expansion.

3. View of some journalists, economists, and investors

The main flaws of the EMH are analogous to those of the long-run competitive theories, which place an excessive amount of emphasis on equilibrium outcomes while paying little to no attention to the entrepreneurial endeavors that are responsible for producing those outcomes. The EMH makes it seem as if there is a distinction between investing in the stock market and investing in a company by stating that there is a difference. The stock market, on the other hand, does not possess a life of its own. Ultimately, the elements that determine the success or failure of any firm are the same ones that play a role in determining the success or failure of any investment in stocks.

The statistical tests that are meant to support the EMH framework are based on a technique that is incorrect, and they fail to realize that the primary source of instability in financial markets is the monetary policies that are implemented by the central bank.

The Efficient Market hypothesis (EMH) is subject to criticism from stock traders because of the anomalies that contradict the EMH. A market anomaly refers to the difference in the price direction between what the EMH establishes and the market prices in reality. Market anomalies occasionally occur without apparent reasons, implying that markets are not always efficient. Stock traders criticize the EMH for this very reason. When the EMH fails to factor in the market anomalies, it is difficult for traders to depend on it for their investment strategies.

There are always several investors and traders who use active investment strategies and have consistently outperformed the market. Moreover, Investors and traders who have been successful in outperforming using fundament and technical analysis also criticize the EMH for its passive investment approach. 

Investors like Warren Buffett and George Soros are household names because of their track records of outperforming the market by purchasing assets at a discount. It’s safe to say that most people would like to be as successful as Buffett and invest in the companies he recommends.

Fines claims that “people like Buffett and Soros have disputed EMH.” They raked in a lot of cash from their ability to foretell people’s actions.

But those who believe in the efficient market hypothesis (EMH) argue that successful investing is more often than not the result of dumb luck. Most of the time, the market behaves in a manner that can be anticipated. They also argue that market collapses and corrections should be seen as the market reverting to some form of the equilibrium point.

Furthermore, data demonstrating that passive funds often outperform active funds are used to support the claim that EMH is a valid hypothesis.

How do investors use the Efficient Market Hypothesis (EMH) in investing in Index Funds?

EMH is a theory that explains the pricing of stocks. It is not an analysis and hence is not helpful in identifying securities for investing. 

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