What is efficient market hypothesis(EMH)?

Is it genuinely possible to beat the market? what is efficient market hypothesis?

Efficient market hypothesis is a concept that describes the degree to which prices of financial assets, such as stocks, bonds, and commodities, reflect all available information.

In an efficient market, prices are believed to fully and accurately reflect all relevant information, making it difficult for investors to consistently earn abnormal or excess returns by trading on this information.

When someone claims that the market is efficient, they are essentially stating that all relevant information, including widely known events or news, is already reflected in the current prices of financial assets.

For example,

If you believe that the release of a new iPhone model will cause Apple stock to rise, I might counter by explaining that this information is already incorporated into the stock price because everyone else in the market is aware of it and has acted accordingly.

Therefore, there would be no need for me to consider that specific information separately since it has already influenced the stock’s current value.

In such a scenario, it indicates that the market is efficient, as it efficiently incorporates all available information to accurately price the stock.

Clearly, not all products exhibit the same level of efficiency, and this holds true within individual product categories as well. For instance, in the stock market, there can be variations in efficiency among different stocks.

What is efficient market hypothesis?

Efficient Market Hypothesis

The Efficient Market Hypothesis (EMH) is a theory that suggests financial markets are efficient in reflecting all available information in asset prices.

According to the EMH, it is difficult for investors to consistently outperform the market or generate excess returns by trading on available information.

The EMH is based on three main forms of market efficiency

Weak form efficiency:

According to the Efficient Market Hypothesis (EMH), asset prices incorporate all relevant past trading information, including historical prices and trading volumes. Consequently, attempting to predict future price movements based on analyzing historical data or patterns(Technical Analysis) is considered infeasible.

Suppose you observe that the price of Apple stock is currently experiencing an upward trend, suggesting a potential increase in the future. Can you utilize this information to predict the stock’s future price and assume that the upward trend will continue?

According to the weak form of market efficiency, the answer is no. This is because such price patterns or trends are readily visible to everyone, and market participants have already taken them into account when making buying or selling decisions. As a result, the current price already incorporates this information, rendering it ineffective for predicting future price movements.

Semi strong form efficiency:

The semi-strong form suggests that asset prices reflect not only past trading information but also all publicly available information.

This includes financial statements, news releases, economic data, and other relevant public information. Therefore, fundamental analysis or attempting to evaluate the intrinsic value of an asset based on publicly available information is not going to help.

In a market that adheres to semi-strong form efficiency, technical analysis and fundamental analysis are considered ineffective.

Strong form efficiency:

This is the strongest form of efficiency proposed by the EMH.

It contends that asset prices reflect all available information, including both public and private or insider information.

Insider information means the information only available to the company CEO or higher management.

If markets were truly strong-form efficient, even insider trading would not provide an advantage, as all information would already be incorporated into asset prices.

Basically according to the strong form of efficiency, neither technical analysis nor fundamental analysis can reliably guide investment decisions. Moreover, even insider information becomes irrelevant since it is likely to have spread through various channels, resulting in enough market participants incorporating that information into the asset prices.

Conclusion

Typically, individuals tend to align themselves with one of the three forms of market efficiency. Different individuals hold varying beliefs regarding market efficiency.

Some adhere to the concept of weak efficiency, where technical analysis is considered ineffective.

Others subscribe to the notion of semi-strong efficiency, which suggests that both technical and fundamental analysis are insufficient, yet insider information might offer an advantage.

Lastly, proponents of strong efficiency argue that technical analysis, fundamental analysis, and even insider information are all futile, leaving no viable means to consistently generate profits.

Do we endorse the idea of strong form efficiency? Clearly not, because if an individual possesses private information that is not accessible to the public and utilizes it for trading, they can indeed make profits. that’s why engaging in such activities is illegal, and those found guilty may face imprisonment.

Now, do we believe in semi-strong efficiency? Some individuals do, and their belief is often rooted in personal experience. Many who hold this belief are individuals who have actively traded in the stock market but have been unsuccessful in consistently outperforming the market.

When faced with the inability to beat the market, they may conclude that the market is efficient. They may attribute their lack of success to the notion that all the information they used to make trades was already reflected in the market, leading them to view the market as a random and unbeatable force.

However, if you were to speak with someone who consistently outperforms the stock market, they would likely argue that the market is quite weak. Different individuals may hold different views based on their success in trading, leading to varying perspectives on the efficiency of the market.

In my opinion, the market is not semi-strong efficient at all because it is evident that fundamental analysis can be utilized effectively to generate consistent profits.

Regarding weak efficiency, which suggests that technical analysis is ineffective, I personally believe that the market is not weak efficient. We observe that many individuals, including myself, successfully use technical analysis to generate profits. Therefore, the ability to make money through technical analysis contradicts the notion of the market being weak efficient.

The presence of numerous inefficiencies in the market provides opportunities to make profits, not only through fundamental analysis but also through technical analysis and even by relying on price action alone.

The stock market, in particular, exhibits inefficiencies. In comparison, the forex market, being vast and highly traded, is considered highly efficient. The agreed-upon exchange rate between currencies in the forex market reflects the consensus of traders worldwide, indicating its true value.

However, the stock market is relatively smaller compared to the forex market. For instance, the forex market trades a significantly larger volume of money in a single day than the entire worth of the US stock market.

Within the stock market, there are smaller companies that experience low trading volumes, such as only 50,000 shares traded daily. In these cases, such companies may not be as efficient in incorporating all available information.

A single large buyer or seller can significantly impact the stock price due to supply and demand dynamics, rather than reflecting actual underlying reasons.

The stock market contains numerous instances of mispricing and inefficiencies, which traders aim to capitalize on. Traders seek to take advantage of these mispricing and the subsequent corrections that occur as a result.