Understanding Efficient Market Hypothesis

Table of Contents

1. Introduction
2. What is Efficient Market Hypothesis (EMH)?
3. Types of Efficient Market Hypothesis
4. Implications of Efficient Market Hypothesis
5. Conclusion

1. Introduction

Hypothesis is a prediction of any research, as an outcome of the study given by the researcher. It involves a possible relationship between two variables one of which is independent and the other being dependent.

In terms of stock market, basic stock investing is a game of good news versus bad news. For instance, any news related to sales report, profit report, etc. are directly linked to stock price; if there is good news regarding sales report of a company, the stock prices are supposed to rise and vice-versa. Thus, in this case the news is an independent variable and the stock price is the dependent variable, on which the prediction of the research of the stock market would be based upon.

Efficient Market Theory has been propounded by Eugene Fama, who is a very renowned American Economist. He had a belief that the stock market is informationally quite efficient, i.e., any data/information/news that comes in the market is automatically absorbed by the stocks. Therefore, any investor in the market cannot make abnormal returns in the long run, reason being that the information is already exhibited in the prices of the securities. For an investor to generate higher returns, the only way out is to make riskier investments.

2. What is Efficient Market Hypothesis (EMH)?

A market is treated as efficient when all the information is immediately discounted by all the investors and reflected in the share prices. For a market to be efficient, there are certain requirements (assumptions) that need to be fulfilled:

• Price must be efficient.
• Information must be discussed freely and quickly with the investors.
• No transaction cost on sale and purchase of securities.
• No taxes.
• Investors are rational.

Efficient Market Hypothesis (EMH) is also called as Random Walk Hypothesis as the future prices/trend of a company cannot be predicted. EMH is an investment theory which suggests that the prices of financial instruments reflect all available market information. Hence, investors cannot have an edge over each other by analyzing the stock and adopting different market timing strategies. Investors can only earn high returns by taking more significant risks in the market.

3. Types of Efficient Market Hypothesis

Efficient Market Hypothesis can be categorized under 3 heads:

3.1 Strong Form of Efficiency

• All information (inside/public) is available in the public domain.
• Share price does not get affected with the information, it is totally market dependent.
• Even the insider knowledge cannot give investors a predictive edge that will enable them to consistently generate returns that outperform the overall market average.

3.2 Semi-Strong Form of Efficiency

• Only historical (past) information is available in the public domain.
• Any positive or negative information shall be fully reflected on the share price.
• It dismisses the usefulness of both technical (the study of past stock prices in an attempt to predict future prices) and fundamental analysis (the study of financial information).
• Prices adjust quickly to any new public information that becomes available, therefore, rendering fundamental analysis incapable of having any predictive power about future price movements.

3.3 Weak Form of Efficiency

• All publicly available information is available in the public domain.
• It implies that technical trading strategies cannot provide consistent excess returns because past price performance cannot predict future price action that will be based on new information.
• It leaves open the possibility that fundamental analysis (company’s financial reports, etc.) may provide a means of outperforming the overall market average return on investment.

4. Implications of Efficient Market Hypothesis

• Investors shouldn’t be able to beat the market because all information (positive/negative) that could predict performance is already built into the stock price.
• The historical share price records can be used as an instrument to measure the performance of the company.
• The market would either underreact or overreact to the latest information in the market, the share price of the company helps in identifying the type of information that affects the market response.

5. Conclusion

Efficient Market Hypothesis is based on the principle that markets are efficient; thus leaving no room to make excess profits by investing since everything is already fairly and accurately priced. The price of any given stock effectively represents the true intrinsic value or fair price of the stock; hence, any time is a good time to buy or sell.