Who: This post is for people who want to know more about the Efficient Market Hypothesis, what it means, and how it can be applied to investment decisions.
What: This post will discuss the Efficient Market Hypothesis with some simple examples and some more complex explanations at the end. The three forms of the hypothesis (weak-form, semi-strong form, and strong-form efficiency) will all be discussed in this post.



What is the Efficient Market Hypothesis? (EMH)

The EMH makes the claim that the prices of assets/securities in financial markets reflect all known public information. In other words, the price of assets in financial markets are determined by the collective outlook of the market participants based on all public knowledge. This implies that any public information about a security has already been taken into account to determine its current price. Simply put, prices in the market are “efficient” and at any given time the price of a security is fair, based on publicly available information.

So, What’s the Big Deal?

-If we assume that the EMH is true, then no one can consistently beat the market by using any sort of “skill.” Any outperformance of the market (with commensurate risk) will be by pure luck.

-In an efficient market, information or analysis that is done to indicate that a stock is a “buy” is not helpful because the outcome of that analysis should already be included in the stock price of the security.

-Any news about changes to a company affect its stock price almost immediately in an efficient market. If the price did not change in response to the news (and it is something that SHOULD have changed the stock price), then there is a point in time which this information is known, and the price does NOT reflect that information. If the EMH is true, this cannot occur.

Three Forms of the EMH

Weak-Form - This is the form of the EMH that is believed by most value investors. The main characteristics are that 1) technical analysis (moving average analysis, price point analysis, etc) will not produce consistent, market-beating returns, 2) one cannot generate returns that beat the market by using analysis and strategies based on historic financial data and 3) insightful fundamental analysis MAY be able to identify undervalued and overvalued stocks and generate market-beating returns.

This is my interpretation of choice because I believe that those with good insights about the future of an industry/company/asset class and those who inquisitively examine financial statements can use publicly available data to make educated guesses about a company’s value that may be BETTER than the market’s guesses as a whole.

Semi-Strong Form - The semi-strong EMH is different from the weak-form in that it implies that fundamental analysis will be unable to consistently produce market-beating returns. The semi-strong version of the EMH states that the introduction of new information into a market will affect stock prices almost immediately, thus making it impossible to gain excess returns by trading on the “new” information. In other words, stock prices quickly react to new public information and as such it is not possible to beat the market consistently.

Strong-Form - This is the exact same as the semi-strong form with one key exception. The strong form of the EMH states that a security’s price reflects ALL information about a company, not JUST public information. In other words, all public and insider information about a company is reflected by the stock price. This is very difficult to justify because of laws prohibiting the public availability of private information.

Conclusions and Questions to Ask Yourself

Do you believe the EMH? If so, which form? Do you think asset managers can consistently beat the market? If you agree with the EMH, then it would seem that index funds would be the best investments, right? (I will be covering this topic very soon). If you do not agree with the EMH (which many people do not), then are index funds REALLY the best choice?

If you’d like to read more about the Efficient Market Hypothesis, here are some cites to my favorite academic papers and a link to one of the best EMH books out there:

The one that started it all:
Fama, E. [1970] “Efficient capital markets: A review of theory and empirical work,” Journal of Finance 25, 383-417.

Efficiency Speed
Gosnell, T., A. Keown and J. Pinkerton [1996] “The intraday speed of stock price adjustment to major dividend changes: Bid-ask bounce and order flow imbalances,” Journal of Banking and Finance 20, 247-266.

Patell, J. and M. Wolfson [1984] “The intraday speed of adjustment of stock prices to earnings and dividend announcements,” Journal of Financial Economics 13, 223-252.

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