What is the efficient market hypothesis?
The efficient market hypothesis (EMH) posits that securities or assets in a market are fairly priced, reflecting all known information that is available for investors to trade on.
One of the premises of the efficient market hypothesis is that because of the relatively level playing field of available information in the stock market, an investor’s portfolio of stocks isn’t likely to outperform the returns of the market because that investor doesn’t have an edge or advantage, even with the use of technical or fundamental analysis. The hypothesis also suggests that any new information that is released is immediately and accurately reflected in the price of a stock.
Eugene Fama & the origin of the efficient market hypothesis
The efficient market hypothesis can be traced back to the 1960s. Eugene Fama, an economics professor at the Booth School of Business at the University of Chicago, wrote his Ph.D. thesis on the hypothesis while at the school, and the topic was mentioned in an article “Random Walks in Stock Market Prices'' published in the Financial Analysts Journal in 1965.
A random walk is a concept that refers to the unpredictable price movement of an asset or security such as a stock and that its future price isn’t dictated or influenced by past price activity. As such, the price movement of a stock is random and isn’t likely to lead to an outperformance in the market, a premise that parallels that of the efficient market hypothesis.
Fama wrote that “an ‘efficient’ market is defined as a market where there are large numbers of rational profit-maximizers actively competing, with each trying to predict future market values of individual securities, and where important current information is almost freely available to all participants.”
He wrote that no analyst is better at predicting the future price movement of a stock than any other market participant unless that analyst has better insight or new information. He added that random stock picking would do better than investing in stocks based on fundamental analysis. From that viewpoint, individual retail investors are better served investing in passive ETFs, such as index funds, rather than in an actively managed fund overseen by a portfolio manager.
In 1970, Fama further detailed the efficient market hypothesis in the article “Efficient Capital Markets: A Review of Theory and Empirical Work,” which was published in The Journal of Finance.
Nowadays, some economists point to high-frequency trading as one factor that contributes to a more efficient market by providing a level-playing field for investors by reducing bid-ask spreads on stocks. A coefficient correlation of zero between a stock and its benchmark shows no correlation but highlights an efficient market, suggesting lower risk to an investor’s portfolio.
Efficient market vs. inefficient market: What’s the difference?
While an efficient market reflects all known information related to a particular stock, an inefficient market is the opposite—one in which prices do not necessarily reflect all available information in a timely manner.
In an inefficient market, for example, an investor may have an advantage over other investors due to having information that isn’t publicly disclosed, such as proprietary information or data. An investor may also have access to insider information on a publicly traded company, giving that investor a possibly unfair advantage over other investors.
Price efficiency and the efficient market hypothesis
Price efficiency—the idea that market prices reflect the latest data and information available to the public—is part of the efficient market hypothesis. Price efficiency, is broken down into three subsets based on the degree of available information and efficiency in a market:
Weak-form efficiency
Prices reflect historical prices. Investors cannot outperform the market based only on historical data.
Semi-strong form efficiency
Prices are adjusted to reflect information that is publicly available, such as earnings releases, stock splits, and dividend payment announcements, as well as historical data. Prices react quickly to the release of information, but investors cannot outperform the market based on new public information or historical data.
Strong-form efficiency
Prices reflect exclusive or private information that isn’t publicly available, in addition to public information and historical data. Because prices react immediately to all new information, investors cannot outperform the market based on new information or historical data.
What are the limitations of the efficient market hypothesis?
The efficient market hypothesis is hypothetical, and as such, it has limitations. A few of those are listed below.
Short-term vs. long-term efficiency
An efficient market may hold sway in the short term, but in the long run, markets may be less efficient due to the unpredictability of fundamental factors such as earnings and dividends. In the long run, returns on a stock may not necessarily continue on an upward, consistent trajectory and may instead move in the opposite direction due to external factors such as higher interest rates as a result of a tightening in monetary policy. Conversely, stocks that had annual declines in previous years could post gains in subsequent years.
Behavioral biases
Investors may also behave irrationally, driving stock prices above or below their fair value—a phenomenon economists and psychologists attempt to understand via behavioral finance. Investors may not necessarily be informed with the best information available, and emotional behavior may affect their investment-making decisions, reducing the efficiency of the market.
Market bubbles and crashes
The efficient market hypothesis may also be less accurate during periods of rising asset prices, asset bubbles, and crashes in financial markets. Proponents of the efficient market hypothesis tend to acknowledge that bubbles and crashes do exist in an efficient market but assert that such phenomena are infrequent and temporary.
In a stock market bubble, some investors may start to pare their investments just prior to a crash. Conversely, following a stock market crash, some may start to invest earlier than others, basing decisions on their own insight in the market. In the financial crisis of 2007–2008, the sudden collapse in the stock market was unpredictable. Some investors had access to information that other investors did not, such as the mismatch on the ratings of securities with different qualities, and that contributed to the crisis.
