Does the Efficient Market Hypothesis actually work?

The efficiency of capital markets is a  topic often debated in the field of investment research.

In financial economics, the Efficient Market Hypothesis (EMH) is a hypothesis that states that security prices adjust rapidly and in an unbiased manner to new information.

According to the EMH, stocks always trade at their fair value on exchanges, making it impossible for investors to purchase undervalued stocks or sell stocks for inflated prices. Therefore, it should be impossible to outperform the overall market through expert stock selection or market timing; and the only way an investor can obtain higher returns is by purchasing riskier investments.

EMH believers think it is meaningless to search for undervalued stocks, or predict trends in the market through either fundamental or technical analysis.

3 Forms of Efficient Market Hypothesis

Weak Form

The weak form hypothesis assumes that security prices reflect all historical information about the trading behavior and price of the market.

The use of technical analysis, charting and regression analysis on historical data would have no predictive power, because an investor trying to examine a security’s past price and history would not be able to find information that would help him to predict future price movements.

Semi-strong Form

The semi-strong form hypothesis assumes that the market reacts quickly to the release of new public information. This includes the release of the latest set of half-yearly or annual results, earnings outlook, new acquisitions or divestitures made by the companies.

Assuming that is true, technical analysis and other charting tools would be ineffective, since examining historical relationships do not provide the investor with new information to enable him to make better predictions about the future movement of security prices.

However, an investor with the knowledge of private inform which is not known to the public, could profit from the insider news since it is not yet to be fully reflected in the security’s price.

Strong Form Hypothesis

The strong form hypothesis assumes that all relevant information about a company, both public news and private information, are already embedded in the price of the security.

Because the hypothesis assumes that any implication from the release of both public and private information are already factored in the security’s price, no investor should have any advantage over another investor in consistently achieving a better than market return.

Does the Efficient Market Hypothesis Really Hold?

Till this day, the EMH still highly controversial and often disputed.

Over the years, many tests have been conducted to verify the validity of the Efficient Market Hypothesis, but the conclusions vary. Tests generally suggest that whilst the market may not be perfectly efficient, it could reasonably be deemed as highly efficient.

While several anomalies exist (eg. January effect, or P/E ratio effect), these anomalies are not conclusive enough to rebuke the EMH since they do not work in a consistent manner across all securities.

On the other side of the arguement, there are investors and portfolio managers out there who seem to be able to outperform the market. This suggests that the market is not 100% efficient.

However, it is not always possible to produce superior returns relative to the market. Therefore, the best strategy to adopt may be based on indexing the portfolio to the market benchmark. Although the EMH has yet to be fully accepted by the finance industry, unless one is able to constantly outperform the market, the EMH theory still holds to a certain extent.

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