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Efficient Market Hypothesis (EMH)

Understand the Theory Behind the Efficient Market Hypothesis (EMH)

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Efficient Market Hypothesis (EMH)

In This Article
  • What is the definition of the efficient market hypothesis (EMH)?
  • Who came up with the original theory behind the efficient market hypothesis (EMH)?
  • What are the three forms of the efficient market hypothesis (EMH)?
  • If the market is efficient, what is the implication on active management?

Efficient Market Hypothesis (EMH) Definition

The efficient market hypothesis (EMH) theorizes about the relationship between the:

  • Information Availability in the Market
  • Current Market Trading Prices (i.e. Share Prices of Public Equities)

Under the efficient market hypothesis, following the release of new information/data to the public markets, the prices will adjust instantaneously to reflect the market-determined, “accurate” price.

EMH claims that all available information is already “priced in” – meaning that the assets are priced at their fair value. Therefore, if we assume EMH is true, the implication is that it is practically impossible to outperform the market consistently.

“The proposition is that prices reflect all available information, which in simple terms means since prices reflect all available information, there’s no way to beat the market.”

Eugene Fama

Market Efficiency 3-Forms (Weak, Semi-Strong & Strong)

Eugene Fama classified market efficiency into three distinct forms:

  1. Weak Form EMH: All past information like historical trading prices and volume data is reflected in the market prices.
  2. Semi-Strong EMH: All publicly available information is reflected in the current market prices.
  3. Strong Form EMH: All public and private information, inclusive of insider information, is reflected in market prices.

EMH and Passive Investing

Broadly put, there are two approaches to investing:

  1. Active Management: Reliance on the personal judgment, analytical research, and financial models of investment professionals to manage a portfolio of securities (e.g. hedge funds).
  2. Passive Investing: “Hands-off,” buy-and-hold portfolio investment strategy with long-term holding periods, with minimal portfolio adjustments.

As EMH has grown in widespread acceptance, passive investing has become more common, especially for retail investors (i.e. non-institutions).

Index investing is perhaps the most common form of passive investing, whereby investors seek to replicate and hold a security that tracks market indices.

In recent times, some of the main beneficiaries of the shift from active management to passive investing have been index funds such as:

The widely held belief among passive investors is that it’s very difficult to beat the market and attempting to do so would be futile.

Plus, passive investing is more convenient for the everyday investor to participate in the markets – with the added benefit of being able to avoid high fees charged by active managers.

EMH and Active Management (Hedge Funds)

Long story short, hedge fund professionals struggle to “beat the market” despite spending the entirety of their time researching these stocks with more data access than most retail investors.

With that said, it seems like the odds are stacked against retail investors, who invest with fewer resources, information (e.g. reports), and time.

One could make the argument that hedge funds are not actually intended to outperform the market (i.e. generate alpha), but to generate stable, low returns regardless of market conditions – as implied by the term “hedge” in the name.

However, considering the long-term horizon of passive investing, the urgency of receiving high returns on behalf of limited partners (LPs) is not a relevant factor for passive investors.

Typically, passive investors invest in market indices tracking products with the understanding that the market could crash, but patience pays off over time (or the investor can also purchase more – i.e. a practice known as “dollar-cost averaging”, or DCA).

Random Walk Theory vs Efficient Market Hypothesis

Random Walk Theory

The “random walk theory” arrives at the conclusion that attempting to predict and profit from share price movements is futile.

According to the random walk theory, share price movements are driven by random, unpredictable events – which nobody, regardless of their credentials, can accurately predict.

For the most part, the accuracy of predictions and past successes are more so due to chance as opposed to actual skill.

Efficient Market Hypothesis (EMH)

By contrast, EMH theorizes that asset prices, to some extent, accurately reflect all the information available in the market.

Under EMH, a company’s share price can neither be undervalued nor overvalued, as the shares are trading precisely where they should be given the “efficient” market structure (i.e. are priced at their fair value on exchanges).

In particular, if the EMH is strong-form efficient, there is essentially no point in active management, especially considering the mounting fees.

EMH Concluding Remarks

Since EMH contends that the current market prices reflect all information, attempts to outperform the market by finding mispriced securities or accurately timing the performance of a certain asset class come down to “luck” as opposed to skill.

One important distinction is that EMH refers specifically to long-term performance – therefore, if a fund achieves “above-market” returns – that does NOT invalidate the EMH theory.

In fact, most EMH proponents agree that outperforming the market is certainly plausible, but these occurrences are infrequent over the long term and not worth the short-term effort (and active management fees).

Thereby, EMH supports the notion that it is NOT feasible to consistently generate returns in excess of the market over the long term.

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