The Efficient Market Hypothesis: Is the Stock Market Efficient?

An important debate among investors is whether the stock market is effective—that is, whether it reflects all the information provided to market participants at any given time. The Efficient Market Hypothesis (EMH) believes that all stocks are perfectly priced according to their inherent investment attributes, and all market participants have this knowledge equally.

Financial theory is subjective. In other words, there are no proven laws in the financial sector. Instead, the idea tries to explain how the market works. Here, let’s take a look at the shortcomings of the efficient market hypothesis in explaining stock market behavior. Although it is easy to see that the theory has many flaws, it is important to explore its relevance in the modern investment environment.

Key points

  • The efficient market assumption assumes that all stocks are traded at their fair value.
  • The weak principle means that the stock price reflects all available information, the semi-strong principle means that the stock price has been considered in all publicly available information, and the strong principle means that all the information has been considered in the stock price.
  • The theory assumes that it is impossible to outperform the market and that all investors interpret the available information in the same way.
  • Although most decisions are still made by humans, using computers to analyze information may make the theory more relevant.

Efficient Market Hypothesis (EMH) Principles and Changes

The three principles of the efficient market hypothesis: the weak, the semi-strong and the strong.

The weaker assumes that the current stock price reflects all available information. Furthermore, past performance has nothing to do with the future trend of stocks. Therefore, it assumes that technical analysis cannot be used to achieve returns.

The semi-strong form of the theory believes that stock prices have been included in all publicly available information. Therefore, investors cannot use fundamental analysis to beat the market and obtain significant gains.

In the strong form of the theory, all information—both public and private information—has been included in the stock price. Therefore, it assumes that no one has an advantage over the available information, whether internal or external. Therefore, it means that the market is perfect, and it is almost impossible to obtain excess profits from the market.

EMH was developed by the economist Eugene Fama’s Ph.D. Papers from the 1960s.

The problem with EMH

Although it sounds good, this theory is not without criticism.

First, the efficient market assumption assumes that all investors perceive all available information in exactly the same way. Different stock analysis and valuation methods have brought some problems to the effectiveness of EMH. If one investor is looking for an undervalued market opportunity, and another investor evaluates the stock based on its growth potential, then the two investors have already made different assessments of the fair market value of the stock. Therefore, an argument against EMH points out that because investors have different valuations of stocks, it is impossible to determine the value of stocks in an efficient market.

Proponents of EMH concluded that investors may profit from investing in low-cost, passive portfolios.

Secondly, under the efficient market assumption, no investor can obtain greater profitability than another investor with the same amount of investment funds. Since they have the same information, they can only get the same return. But please consider the wide range of investment returns obtained by investors, investment funds and other fields. If no investor has any obvious advantage over another investor, will the mutual fund industry have a series of annual returns, from huge losses to 50% or more profits? According to EMH, if an investor is profitable, it means that every investor is profitable. but it is not the truth.

Third (closely related to the second point), under the assumption of an efficient market, no investor should be able to outperform the market or the average annual return that all investors and funds can achieve through their best efforts. This naturally means that, as many market experts often insist, the absolute best investment strategy is to put all one’s investment funds into index funds. This will increase or decrease according to the overall level of corporate profit or loss. But many investors have been outperforming the market. Warren Buffett is one of those people who have exceeded the average year after year.

Obtain EMH qualification

Eugene Fama never thought that his effective market would always be 100% effective. This is impossible because stock prices need time to react to new information. However, the valid assumption does not give a strict definition of how long it will take for the price to recover to fair value. In addition, in an efficient market, random events are completely acceptable, but as prices return to normal, they will always be eliminated.

But it is important to ask whether EMH destroys itself by allowing random or environmental events. There is no doubt that this possibility must be considered in the context of market efficiency, but by definition, true efficiency immediately accounts for these factors. In other words, prices should react almost immediately with the release of new information that may affect stock investment characteristics. Therefore, if EMH allows inefficiency, it may have to admit that absolute market efficiency is impossible.

Improve market efficiency?

Although it is relatively easy to pour cold water on the efficient market hypothesis, its relevance may actually be growing. With the rise of computerized systems for analyzing stock investments, transactions, and companies, investments are becoming more and more automated based on rigorous mathematics or basic analysis methods. At the right power and speed, some computers can process any and all available information at once, and even convert this type of analysis into immediate execution of transactions.

Despite the increasing use of computers, most decisions are still made by humans, so human errors are prone to occur. Even at the institutional level, the use of analytical machines is not universal. Although the success of stock market investment mainly depends on the skills of individual or institutional investors, people will continue to look for foolproof ways to obtain higher returns than the market average.

Bottom line

It is safe to say that the market will not reach perfect efficiency anytime soon. In order to be efficient, all these things must happen:

  • Universal access to high-speed and advanced pricing analysis systems.
  • A generally accepted stock pricing analysis system.
  • There is absolutely no human emotion in investment decisions.
  • All investors are willing to accept that their returns or losses will be exactly the same as all other market participants.

It is hard to imagine that any of these market efficiency standards have ever been met.

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