Efficient market hypothesis (EMH) is an investment theory that implies that all information related to securities gets reflected into their respective prices. It is also termed as an efficient market theory which is actually a hypothesis not existing in the real market. The efficient market hypothesis (EMH) states that stocks trade at their fair values on stock exchanges making it impossible for investors to either buy the undervalued stocks or sell stocks at inflated prices. The investors can’t outperform the overall market via doing the selection of expert stocks or market timing. No matter what amount of analysis is being performed, investor can’t get edge over the market. Efficient market hypothesis says that there is only one way available in which investors can increase their returns which is buying of riskier investments.
This investment theory requires an investor to act randomly instead of behaving rationally. Manytimes, the EMH can also be controversial although being a key pillar of modern financial theory. It is claimed by many believers that using either fundamental or technical analysis for looking undervalued stock or forecasting the market movements is fully ineffectual. In theoretical terms, neither the fundamental nor technical analysis can provide risk-adjusted excess returns (alpha).
Types of Efficient Market Hypothesis
There are 3 types of efficient market hypothesis which are as discussed in points given below: –
- Weak form EMH: Weak form of efficient market hypothesis denotes that each and every public information regarding market is reflected into price of securities. However, the price can’t tell the new information which is not yet released publicly. Weak form EMH is based on assumption that future prices of securities are independent and not linked in any way to their past prices, volume and returns.It further implies the non-possibility of earning excess returns in long run using the technical trading strategies. This is because the past price information cannot be utilized for predicting the future price action which is completely based on new set of information. The fundamental analysis can assist in making returns over the average market rate in short run by providing information. But in long term, fundamental analysis will not offer an advantage and technical analysis will not work.
- Semi-strong form EMH: Semi-strong form of efficient market hypothesis clearly disapproves the utility of both fundamental and technical analysis. It implies neither the fundamental analysis nor technical analysis can provide you advantage. Semi-strong form has incorporated the assumptions of weak-form EMH and further expanded on this theory by saying, the new public information quickly gets priced into securities. There are instant adjustments which take place in market prices in accordance with any newly disclosed public information. Therefore, there is no scope for using the both fundamental and technical analysis, and does not possess any predictive power for price movements in future. For instance, in U.S. non-farm payroll report which is released on monthly basis, rapid price changes take place in response to the new information released in the market.
- Strong form EMH: The strong-form of EMH defines that both historical as well as current information are reflected in market price of securities. The information here relates to publicly disclosed information and the insider information. Even the private information not made public and available only to CEO of company is assumed to be reflected into the present stock price of companies. Strong EMH says that earning an abnormal high return is quite impossible thing. The investors by utilizing the insider knowledge also can’t get predictive edge for securing returns above overall market average.
Advantages of Efficient market hypothesis
Various advantages of efficient market hypothesis are as follows: –
- Saves money of innocent investors: The major advantage provided by efficient market hypothesis is that it saves money of lot of innocent peoples. Many peoples enter into stock market with the motive of earning huge profits via following the advice of technical and fundamental analysts. But in reality, the small investors buy securities at inflated price and end up selling them at losses. Therefore, the efficient market hypothesis makes it quite clear that stock market is a speculative game where no one can earn abnormal returns consistently.
- Saves time: The efficient market hypothesis saves a lot of time of people willing to do investment in stock market. There is no need to do a lot of research and analysis of profit & loss account, balance sheet and stock’s technical chart once it is known that market is efficient. No one can make abnormal returns simply on the basis of these analyses. This theory says just like in case of speculation gut feeling is used for placing bets, in similar way gut feeling should be used for buying or selling stocks without any research or analysis.
- Neutralizes self-made experts: Another big advantage of efficient market hypothesis is that it saves peoples form trap of self-made stock market experts. Once it is known that market is efficient and price of securities reflects all its related information. Therefore, it is completely waste to buy/sell stocks on the basis of recommendations of these experts.
Disadvantages of Efficient market hypothesis
The disadvantages of efficient market hypothesis are listed below: –
- Markets are irrational: The first major drawback of efficient market hypothesis is its argument regarding market to be efficient. There is long history of examples in past where stock market become irrational. Stocks were available at throwaway prices and people make large money by purchasing such stocks. Therefore, the EMH argument that market timing can do anything gets failed seeing the irrational nature of markets. It is possible to make high returns by buying stock at undervalued prices during market crash and selling them at overprice during market exuberance.
- Fundamental and technical analysis works: It is incorrect to say that fundamental and technical analysis are no of use. There might be chances of bad results using these 2 analyses while investing but it may also vary on the basis of good or bad technical/fundamental analyst. Just saying it is non-useful is not a right thing as there are numerous people who want to earn consistently above normal return utilizing fundamental as well as technical analysis.
- Stock market is not gambling: The efficient market argues that stock market is a gambling which is totally wrong. In gambling, bets are placed by people on the basis of gut feeling whereas in stock market investment decisions are taken on the basis of numerous factors such as market trends, technical trends, company’s financial position, stock as well as economic new.