- The efficient market hypothesis (EMH) says that all information is priced into securities at any given time.
- Proponents believe that since stocks are always fairly valued, active investing strategies cannot beat the market.
- Critics counter by pointing to investors such as Warren Buffett and George Soros, who can and do outperform the market.
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The efficient market hypothesis (EMH) holds that stocks are always fairly valued because their prices reflect all the information available. Therefore, proponents argue, there's no way for an individual to meaningfully increase their returns relative to the rest of the market.
Efficient market hypothesis basics
The efficient market hypothesis says that the markets are privy to any and all available information, and that securities are priced accordingly. In other words, all the stocks on a given exchange or index such as the S&P 500 are trading at a fair price. So, in theory, it shouldn't be possible for an investor to outperform the index using any sort of strategy or analysis.
Further, EMH proponents say, when new information about a company does come to light, it's immediately and instantaneously priced into the stock. With that, an active stock picker would theoretically have just as much success picking a bunch of stocks at random. If the theory were to hold true, each approach would yield roughly the same returns.
"The theory would have it that if you believe in efficient markets, you cannot believe in the construction of an optimized portfolio, because, by definition, you cannot use past returns to predict the future," says Olivier Fines, the CFA Institute's head of advocacy for the EMEA region.
With all of this in mind, it would make sense that a passive approach to investing, which has been gaining popularity, would be better than an active approach.
"The idea is that there's no point in thinking that you can consistently beat the market, because there's no theoretical basis for that to be the case," Fines says. "A price at any given time reflects everything there is to know — any move, therefore, is pure randomness."
Fines says that the efficient market hypothesis has its roots in the 1960s, when it started to emerge into the mainstream through the work of economists Eugene Fama and Paul Samuelson . Each of them, independently and through their own research methods, developed the basic framework behind the efficient market hypothesis, which laid the groundwork for the theory going forward.
But at its core, EMH concerns the flow and availability of information, along with the assumption that the information is being taken into consideration. That has led to three main "forms" or types of EMH being hypothesized.
What are the types of EMH?
The efficient market hypothesis says that the market exists in three types, or forms: weak, semi-strong, and strong. Here's a little more about each:
- Weak form : This is base-level EMH. The weak form theorizes that past data and information from the market is priced into stock prices. This form really only concerns data from the past, however, and doesn't take into account information that may not be privy to some investors.
- Semi-strong form : This posits that all public information is reflected in a stock's price. The key word here is "public." There may be private or other information out there that can give an investor an edge in trading.
- Strong form : The strong form says that all information out there — public and private — has been accounted for and is reflected in current market prices.
The three forms are like filters, each assuming that a certain subset of information has found its way to the market and has thus been priced in. And since all of the information is out there, there's really nothing that can cause a price change. Therefore, no form of expertise or tactical trading can help increase returns.
Arguments for and against EMH
Of course, there's a problem with the efficient market hypothesis: some investors can and do beat the market. That's one of, and perhaps the chief argument against EMH, typically made by proponents of active investment management.
Warren Buffett and George Soros are two of the best-known investors who have consistently beaten the market by investing in assets that they felt were undervalued. Buffett, in particular, has inspired legions of investors to follow his stock picks.
EMH "has been challenged by the likes of Buffett and Soros," says Fines. "They made a lot of money by predicting human behavior."
Proponents of EMH counter that investors beating the market are mostly just lucky. By and large, the market moves in a fairly predictable way most of the time. The existence of market crashes and corrections, too, can be viewed as the market returning to a baseline of sorts, they say.
Proponents also point to data showing that passive funds beat active funds with regularity as evidence that EMH is a sound theory.
How is EMH used in investing?
The influence of the efficient market hypothesis is evident in the markets with the rise and increasing popularity of passive investing . Passive investing , as opposed to active investing, involves strategies in which an investor looks to match the market — not beat it.
While there are numerous reasons that a passive approach may be best for many investors (lower costs and risks, for example), the fact that passive strategies are becoming so popular may serve as vindication for EHM proponents.
Consider this: Over the past six years, the percentage of passive funds (versus active) has risen from 31.6% to 42.9%, according to data from Bloomberg Intelligence . And it's expected that passive funds will overtake active funds, perhaps as soon as 2026.
The financial takeaway
The efficient market hypothesis states that any and all available information regarding a stock is priced into its value at any given time. That's to say that the market is perfectly efficient — more efficient than an active investor trying to beat the market at large.
In short, if you think you can beat the market by picking stocks, you probably don't think the EMH holds much weight. However, the popularity of passive and index investing may be an indication that the EMH has been adopted by many investors, whether they realize it or not.
Via PakApNews