The Efficient Market Hypothesis (EMH) is a theory in financial economics that states that financial markets are “informationally efficient,” meaning that the prices of securities reflect all publicly available information at any given time.
This theory has several forms, including weak, semi-strong, and strong form:
- The weak form of EMH states that past prices and trading volumes of a security cannot be used to predict its future price.
- The semi-strong form of EMH states that not only past prices and trading volumes but also all publicly available information (e.g., financial statements) cannot be used to predict the future price of a security.
- The strong form of EMH states that even insider information cannot be used to predict the future price of a security.
The EMH was first proposed by Eugene Fama in the 1960s, and it has been a topic of debate among economists and finance scholars ever since. The theory suggests that it is impossible to consistently achieve higher returns than the market average by using any publicly available information, and that markets are always perfectly efficient.
However, many researchers and practitioners have argued that the EMH does not hold up in practice. For example, studies have shown that certain technical and fundamental strategies can lead to higher returns than the market average, which would imply that markets are not perfectly efficient. Additionally, behavioral finance research has shown that individual investors are prone to cognitive biases that can lead to inefficiencies in the market.
It’s also worth noting that the different forms of the efficient market hypothesis have different levels of acceptance among academics and practitioners. The weak form, which states that past prices and trading volumes can’t be used to predict future prices, is widely accepted and supported by empirical evidence. However, the semi-strong and strong forms, which state that all publicly available information and insider information can’t be used to predict future prices, respectively, have been subject to more debate and criticism.
Critics of the EMH argue that it is overly simplistic and that markets are not always perfectly efficient. They point to examples such as bubbles and crashes, insider trading, and other market anomalies that are difficult to explain under the EMH.
There are several reasons why the efficient market hypothesis (EMH) is considered to be flawed:
- Behavioral biases: Studies in behavioral finance have shown that individual investors are prone to cognitive biases such as overconfidence, herding, and emotional reactions that can lead to inefficiencies in the market.
- Insider trading: The EMH assumes that all investors have access to the same information, but in reality, some investors may have access to inside information that can give them an unfair advantage.
- Market manipulation: Manipulation of the market by large investors or market participants can also lead to inefficiencies and deviations from the EMH.
- Anomalies: Studies have shown that certain investment strategies, such as value investing, can lead to higher returns than the market average. This contradicts the EMH’s claim that it is impossible to achieve higher returns than the market average.
- Complexity: Real-world markets are far more complex than the EMH assumes, with multiple actors, regulations, and other factors that can influence prices and create inefficiencies.
- Limited data availability: EMH is based on the assumption that all relevant information is publicly available, but in reality, there may be important information that is not publicly available.
- Short-term vs Long-term: EMH assumes that markets are always perfectly efficient, but there are instances when markets can be inefficient in the short term but still efficient in the long-term.
- Market structure: EMH assumes that markets are frictionless and that it is easy for investors to buy and sell securities, but in reality, transaction costs and other market frictions can affect prices and create inefficiencies.
While it’s generally accepted that markets are not perfectly efficient and that certain investment strategies can lead to higher returns than the market average, the EMH remains an important concept in finance and economics and continues to be studied and debated by academics and practitioners alike.