What is the efficient market hypothesis (EMH)?

What is the efficient market hypothesis?

The efficient market hypothesis (EMH) is an economic and investment theory that attempts to explain how financial markets move. It was developed by economist Eugene Fama in the 1960s, who stated that the prices of all securities are completely fair and reflect an asset’s intrinsic value at any given time.

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When people talk of efficient markets, they are describing a situation in which all the decisions of market participants are completely rational and that they consider all of the information available. EMH believes this to be true and so states that the market price will always be completely accurate, as all new information will be priced in immediately.

EMH argues that the only volatile movements occur after unexpected news, but that once the information is digested, the efficient market resumes.

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Following this theory, it would be impossible for individual traders, investors and fund managers to ‘beat’ the market – which is the phrase used to describe gaining returns that are larger than the market average. This is because there would be no such thing as an overvalued or undervalued stock. EMH in its strongest form renders fundamental and technical analysis completely devoid of purpose, as there is no information that could produce oversized returns, other than insider trading.

Because of this EMH is highly controversial, and although it has a large following, it also faces a large amount of criticism.

What are the forms of the efficient market hypothesis?

There are three different forms of the efficient market hypothesis:

1. Weak
2. Semi-strong
3. Strong

Weak form EMH

Weak form EMH assumes that the current market price reflects all historical price information about a security’s price. The argument for weak EMH is that all new price movements are unrelated to historical data. So, those who believe this theory think that all future share price movements cannot be predicted based on previous price moves – essentially, the market is completely unpredictable as explained in random walk theory.

If a market is deemed to be ‘weak-form efficient’, it would mean that no correlation exists between historical prices and successive prices. This would mean that fundamental analysis might help traders to gather information and produce above-average returns, but that no patterns exist within price charts – therefore technical analysis is an inefficient methodology for entering and exiting weak-form efficient markets.

Semi-strong form EMH

Proponents of semi-strong form EMH believe that all publicly available information is factored into the market price. The theory states that the study of this information – which could include company balance sheets and historical share prices – could not result in oversized results.

A semi-strong form efficient market would mean that neither fundamental or technical analysis could provide advantageous information, as all new information is instantly priced into the market. Semi-strong EMH believes that only those with privately held information could hold an advantage.

Those who believe semi-strong form EMH would question the need for a large portion of financial services, such as analysts and investment researchers.

Strong form EMH

Strong form EMH states that all available information, both public and private, is priced into the price of a security. This would mean that no investor would consistently be able to beat the market as a whole, but that some individuals might make abnormal returns on occasion.

Strong form EMH assumes that the market is perfect, and so the only way an individual could make an excessive return is by using insider information. Both technical and fundamental analysis would be rendered moot, as neither could provide advantageous information.

How do traders and investors look at efficient markets?

How a trader or investor views efficient markets and EMH theory will completely depend on their view as to whether an individual or fund is able to beat the stock market. This debate is centred around passive and active investing and trading.

Passive investors will tend to support EMH and so choose to focus on index funds or exchange traded funds (ETFs) that simply mirror the underlying, offering the same returns as the overall market. They do not attempt to beat the average returns or engage in risk taking. Traders and investors who believe in EMH think that the only way to earn more than the underlying market is to accept excessive risk.

These individuals will be less likely to invest through fund managers, as they do not believe they will be able to outperform the market. However, this does also mean that investors who do consistently outperform the market become famous for doing so.

Critics of EMH are usually active investors or speculators, who believe that it is possible to beat the market average because there are inefficacies within financial markets. These participants will often not focus on funds at all, preferring to trade the individual stocks of companies.

These include both technical traders, who focus on short-term patterns and historical prices, and fundamental traders, who use public information and analysis to identify oversold and overbought stocks. They would take advantage of efficient markets by investing in stocks or ETFs or by using derivative products – such as CFDs and spread bets – to speculate on both rising and falling markets.

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Proponents of EMH

After EMH was published by Fama in the 1960s, it remained extremely popular in both economic and business studies – and most research seemed to back up the assumptions made by EMH.

Even today, there are still arguments in favour of EMH, including:

1. The outperformance of passive funds
2. The presence of arbitrage opportunities

The outperformance of passive funds

The increasing popularity of passive investing through mutual funds and ETFs is often cited as evidence that people still support EMH. In theory, if EMH is incorrect and markets are inefficient, then active funds should gain higher returns than passive funds. However, this often isn’t the case over a long time period.

A study by Morningstar found that over the ten-year period ending June 2019, just 23% of active funds surpassed the average returns of their passive counterpart.¹ Proponents of EMH cite this study, and others like it, as evidence that markets are efficient and that over the longer-term, EMH holds up.

However, an argument has been made that if passive investing grows too much, it could have an adverse impact on the efficiency of markets. As active investors support research, trading and market monitoring, all of which is vital for well-functioning markets.

For a truly efficient market, there needs to be a mix of both passive and active participants. While active investors are considered ‘informed’ – in that they have collected all the information available in order to exploit market inefficiencies – they are still dependant on other ‘uninformed’ traders to take the other side of their trade. But if people opt out of this risk by trading financial markets passively, then there will be fewer opportunities in theory.

It remains to be seen whether regulatory bodies will take action on the growing imbalance between active and passive funds in order to maintain market efficiency. The Financial Conduct Authority (FCA) has previously said that it would consider corporate governance of how many shares can be owned by passive funds in order to encourage active investing.²

The presence of arbitrage opportunities

Another argument in favour of EMH is the presence of arbitragers. These are individuals who buy an asset from one marketplace and sell the same asset in another to take advantage of price differences. Arbitragers will look out for an asset whose price is out of line with expectations and bring it back to its true value – capitalising on the market move as it happens.

If we use a long position as an example, these arbitragers would identify stocks that are trading below their true value, in order to ‘buy low and sell high’. It is these traders who drive the asset toward its fundamental value.

This is the strategy that underpins the EMH theory, as it relies on individuals to ensure that market prices reflect the available information accurately.

Critics of EMH

Over the years, many criticisms of EMH have emerged. We’ve taken a look at just a few of the popular arguments against the theory, which include:

1. Market bubbles and crashes
2. Market anomalies
3. Behavioural economics
4. Investors have beaten the market

Market bubbles and crashes

Speculative bubbles occur when an asset’s price increases beyond its fair value to the extent that, when the market correction occurs, prices fall rapidly and a financial crash takes place.

According to the efficient market hypothesis, market bubbles and financial crashes should not occur. In fact, the theory would argue they cannot exist as an asset’s price is always accurate.

For example, Fama actually argued that the 2008 financial crisis was a result of an impending recession rather than a credit bubble. He argued that it cannot have been a speculative bubble, as this would be predictable rather than just seen in hindsight.

However, many critiques of Fama’s explanation point out that the credit bubble was predictable, as evidenced by those who bet against the credit default option market and made millions.

When a financial bubble occurs, it does not mean that there is no consensus about the price of an asset, it just means that the consensus is wrong. In the case of the 2008 financial crash, the market participants were ignoring vital market information in order to keep boosting the credit options market. This prospect goes against everything that EMH stands for.

Market anomalies

Market anomalies describe a situation in which there is a difference between a share price’s trajectory as set out by EMH, and its actual behaviour. In practice, efficient markets are near impossible to maintain, and the presence of anomalies is a symptom of this.

Market anomalies occur for different reasons, at different times and have different effects. But they all prove that markets are not always efficient, and that individuals do not always act rationally.

If markets were truly rational then calendar anomalies such as the January effect, would not exist – because they have no true explanation behind them, other than that people believe they will happen. In some respects, they are a self-fulfilling prophecy.

And if the market price contained all available information then post-earnings-announcement drift would not have such a hold over the market. This anomaly in particular contradicts EMH theory, as it describes the phenomena of pricing continuing to move in the direction of an earnings surprise. If EMH were accurate, then new information would be priced in immediately, however this anomaly shows that markets can be slower to adjust.

Behavioural economics

The introduction of the field of behavioural economics has also been used to criticise EMH. The idea that market participants are, on the whole, rational has increasingly come into question as we learn more and more about the psychology of trading.

Behavioural economics also goes some way to explaining the market anomalies described above. Social pressures can cause individuals to make irrational decisions, which can cause traders to make errors and take on a larger amount of risk than they otherwise would. Especially the phenomena of herding, which describes individuals ‘jumping on the bandwagon’, is evidence that not all decisions are rational and based on information.

Even factors such as a trader or investor’s personality traits or emotions can have a significant impact on how they behave and the way they interact with the market.

Investors have beaten the market

There are investors who have consistently beaten the average market. Of course, the most famous is Warren Buffett – his company Berkshire Hathaway outperformed the S&P index 73% of the time between 2008 and 2018.

Buffett does not believe the EMH himself and has been a vocal critic of the passive approach to investing. Instead Buffett takes a value investing approach, which seeks to identify undervalued stocks through fundamental analysis.

Buffett does concede that EMH is a persuasive enough argument that it is understandable why many investors choose index funds and ETFs. Buffett himself has never invested in an index fund.

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As the popularity of passive investing increases, the remaining active and value investors will have less competition, which could see them generate higher returns.

Can you beat the market or are they always efficient?

As proven by Warren Buffett, and others like him, it is possible to beat the market. However, it would completely depend on the strategy you put in place, how much risk you’d be willing to take on and the way in which you’d deal on financial markets.

A lot of traders and investors will recognise that certain markets are more efficient than others and build their strategy accordingly – using passive funds for highly efficient markets, and active funds for less efficient markets.

Regardless of whether you believe EMH is accurate or not, to start trading or investing in financial markets you’ll need to:

1. Build your knowledge using IG Academy
2. Create a live account to either trade or invest
3. Open your first position

Alternatively, you could practise trading CFDs and spread bets in a risk-free environment using an IG demo account.

Efficient market hypothesis summed up

• The EMH is an economic and investment theory that attempts to explain how financial markets move
• It assumes that the prices of all securities are completely fair and a true reflection of an asset’s intrinsic value at any given time
• According to the theory, the market price will always be completely accurate, as all new information will be priced in immediately
• EMH argues that it would be impossible for individual traders, investors and fund managers to ‘beat’ the market
• There are three different forms of the efficient market hypothesis: weak, semi-strong and strong
• How a trader or investor views efficient markets will completely depend on their view as to whether an individual or fund is able to beat the stock market
• Passive investors will tend to support EMH and so choose to focus on index funds or ETFs that simply mirror the underlying, offering the same returns as the overall market
• Critics of EMH are usually active investors or speculators, who believe that it is possible to beat the market average because there are inefficacies within financial markets
• EMH remains popular based on the success of passive investing and the opportunities for arbitrage
• However, the theory faces a lot of criticism due to its lack of explanation for market bubbles, crashes and anomalies, the introduction of behavioural economics, and the clear successes of active investors
• It is possible to beat the market if you have the correct strategy and understanding of financial markets

¹ Morningstar, 2019

² FCA, 2019