Efficient Market Hypothesis (EMH)
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What is the Market Efficiency Hypothesis (EMH)
The Market Efficiency Hypothesis (EMH) is an investment theory in which stock prices reflect all information and consistent alpha earnings are not possible.
In theory, neither technical analysis nor fundamental analysis can consistently lead to excess risk-adjusted returns ( alpha returns ), and these are derived from inside information only.
According to the EMH theory, stocks on stock exchanges are always traded at fair value, which makes it impossible to both buy undervalued stocks and sell them at overvalued prices.
Thus, no one can beat the overall market performance by expert stock selection or trade entry timing, and the only way an investor can get higher returns is by purchasing riskier investments.
Analyzing the Market Efficiency Hypothesis (EMH)
While the market efficiency hypothesis is a cornerstone of modern financial theory, it is highly controversial and often questioned.
Its supporters argue that it is pointless to look for undervalued stocks or try to predict trends using fundamental or technical analysis .
While scholars point to a large body of evidence to support this theory, there are just as many rebuttals.
For example, investors like Warren Buffett have consistently earned above the market average for extended periods of time, which is by definition not possible under the EMH.
Critics of the efficient market hypothesis (EMH) also recall events such as the stock market crash in 1987, when the Dow Jones Industrial Average (DJIA) fell more than 20% in one day, suggesting that stock prices can deviate significantly from their fair value.
What does EMH mean for investors
EMH supporters believe that due to the chaotic market movements, investors could do better by investing in a low-cost, passively managed portfolio.
Data collected by Morningstar Inc. in a study for the June 2015 Active / Passive Barometer bulletin, confirm this finding.
Morningstar compared the returns of active managers of all categories to the combined returns of related index and exchange-traded funds (ETFs).
The study showed that over the years, only two groups of active managers successfully outperformed passive funds in more than 50% of cases.
These were small US growth funds (investment funds that reinvest a significant share of profits) and diversified emerging market funds.
In all other categories, including US Large Blend, US Large Value, and US Large Growth, investors would do better by investing in low-cost index funds or ETFs.
Although a small proportion of active managers manage to outperform passively managed funds, it is quite difficult for an investor to determine which manager will be able to achieve this this time.
Less than 25% of the active managers with the highest returns can regularly outperform their peers in passive funds.
Related terms
Informationally Efficient Market
The information efficient market theory broadens the definition of the standard efficient market hypothesis.
Weak Form Efficiency
Weak form efficiency is one of the degrees of the market efficiency hypothesis, which states that all past stock prices are reflected in their current price.
Semi-Strong Form Efficiency
Semi-Strong Efficiency is a form of the Market Efficiency Hypothesis (EMH), which assumes that all publicly available information is accounted for in stock prices.
Chasing the Market
Chasing the market refers to entering or exiting an investment instrument in order to profit from an ongoing movement or trend.
Trading strategy
A trading strategy is a method of buying and selling assets in the markets based on predefined rules used to make trading decisions.
Order ” At The Market “
An At The Market order allows you to buy or sell a stock or futures contract at the prevailing bid or ask price at the time it is processed.
