The Efficient Market Hypothesis (EMH) is a theory in finance, that provides a framework to understand how financial markets function and how asset prices are determined. Developed in the 1960s by economists such as Eugene Fama, the EMH posits that financial markets are informationally efficient, meaning that asset prices reflect all available information at any given time.
In this article, we’ll explore the efficient market hypothesis and figure out if it’s possible to outperform the market.
What is Efficient Market Hypothesis?
Is it really possible to outperform the market? Let’s dive into the efficient market hypothesis to find out.
The efficient market hypothesis is a theory explaining how well financial assets like stocks, bonds, and commodities reflect all the information available. In a nutshell, it suggests that in an efficient market, prices accurately represent all relevant information. This means it’s tough for investors to regularly make more money than what the market’s already showing.
So, when someone says the market is efficient, they’re saying that all the essential info, like big news or widely known events, is already factored into asset prices. Take, for example, the launch of a new iPhone. If you think this will boost Apple’s stock, I might counter by saying the stock price already accounts for this because everyone else knows about it too and has adjusted their actions accordingly.
In such cases, it shows the market is efficient—it’s swiftly factoring in all the available info to set the stock price. But not every product or category behaves the same way. Even within stocks, there can be differences in efficiency among different companies.
The Efficient Market Hypothesis (EMH) suggests that financial markets are pretty good at reflecting all the available info in asset prices. According to this theory, investors find it hard to consistently do better than the market or earn extra returns by trading on available info.
The EMH is based on three main forms of market efficiency:
Weak Form Efficiency:
According to the Efficient Market Hypothesis (EMH), asset prices include all the relevant past trading information, like historical prices and trading volumes. So, trying to forecast future price movements by analyzing historical data or patterns in simple terms Technical Analysis isn’t likely to work.
Let’s say you notice that the price of Apple stock is going up, hinting at a possible increase in the future. Can you use this info to predict where the stock price will go and think the upward trend will keep going?
Well, according to the weak form of market efficiency, the answer is no. That’s because these price patterns or trends are obvious to everyone, and folks in the market have already factored them in when deciding to buy or sell. So, the current price already reflects this info, making it useless for guessing future price moves.
Semi-Strong Form Efficiency:
The semi-strong form says that asset prices show not just past trading info but also all the info available to the public.
That means stuff like financial reports, news, economic updates, and other important public info. So, trying to figure out the real value of an asset using public info, known as fundamental analysis, won’t do much good.
In a market that’s semi-strong, both technical and fundamental analyses don’t really work.
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 is 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.
Is it Possible to Outperform the Markets?
Usually, people tend to lean towards one of the three forms of market efficiency. Different folks have different opinions about how efficient the market is.
Some stick with weak efficiency, where technical analysis isn’t seen as useful.
Others go for semi-strong efficiency, saying both technical and fundamental analyses don’t cut it, but insider info might help.
Then there are those who support strong efficiency. They argue that technical analysis, fundamental analysis, and even insider info won’t do you any good, so making consistent profits isn’t really possible.
So, do we believe in strong efficiency? Not really. Because if someone has private info that others don’t and uses it for trading, they can make money. That’s why doing that is against the law, and if caught, you might end up in jail.
Now, do we believe in semi-strong efficiency? Some do. They often base this belief on their own experiences. Many of them have traded stocks but couldn’t beat the market regularly.
When they can’t do better than the market, they might think the market is efficient. They might think their lack of success is because all the info they used was already in the market, making it seem like a random and unbeatable force.
But if you talk to someone who regularly beats the stock market, they’d likely say it’s not very efficient. Different people might have different views based on how successful they are in trading, leading to different ideas about how efficient the market is.
In my opinion, the market isn’t semi-strong efficient at all. It’s clear that fundamental analysis can be used to make consistent profits.
As for weak efficiency, which says technical analysis doesn’t work, I don’t think the market is weak efficient. Many people, including myself, use technical analysis to make money successfully. So, the ability to make money using technical analysis goes against the idea of the market being weak efficient.
There are lots of inefficiencies in the market, which means there are chances to make money, not just through fundamental analysis, but also through technical analysis or just by watching price movements.
The stock market, especially, has inefficiencies. In contrast, the forex market, being so big and heavily traded, is seen as highly efficient. The agreed-upon exchange rate between currencies in the forex market shows what traders all over the world think it’s worth.
However, the stock market is smaller compared to forex. For example, forex trades a lot more money in one day than the whole US stock market is worth.
In the stock market, there are smaller companies with low trading volumes, like only 50,000 shares traded daily. In these cases, those companies might not be as good at taking in all the info available.
One big buyer or seller can really change the stock price due to supply and demand dynamics, not necessarily because of the real reasons behind it.
The stock market has lots of times when prices aren’t quite right, which traders try to take advantage of. They try to make money from these mistakes and the fixes that happen afterwards.
Conclusion
In essence, the Efficient Market Hypothesis (EMH) outlines how asset prices reflect available information. It categorizes market efficiency into weak, semi-strong, and strong forms. While some argue for market efficiency, others point to market inefficiencies as opportunities for profit. Ultimately, the debate underscores the importance of understanding market dynamics for successful investing.