The Efficient Market Hypothesis (EMH) is one of the main reasons some investors may choose a passive investing strategy. It helps to explain the valid rationale of buying these passive mutual funds and exchange-traded funds (ETFs).
What Is Efficient Market Hypothesis?
The Efficient Market Hypothesis (EMH) essentially says that all known information about investment securities, such as stocks, is already factored into the prices of those securities. If that is true, no amount of analysis can give you an edge over "the market."
EMH does not require that investors be rational; it says that individual investors will act randomly. But as a whole, the market is always "right." In simple terms, "efficient" implies "normal."
For example, an unusual reaction to unusual information is normal. If a crowd suddenly starts running in one direction, it's normal for you to run that way as well, even if there isn't a rational reason for doing so.
What Are the Types of EMH?
There are three forms of EMH: weak, semi-strong, and strong. Here's what each says about the market.
- Weak Form EMH: Weak form EMH suggests that all past information is priced into securities. Fundamental analysis of securities can provide you with information to produce returns above market averages in the short term. But no "patterns" exist. Therefore, fundamental analysis does not provide a long-term advantage, and technical analysis will not work.
- Semi-Strong Form EMH: Semi-strong form EMH implies that neither fundamental analysis nor technical analysis can provide you with an advantage. It also suggests that new information is instantly priced into securities.
- Strong Form EMH: Strong form EMH says that all information, both public and private, is priced into stocks; therefore, no investor can gain advantage over the market as a whole. Strong form EMH does not say it's impossible to get an abnormally high return. That's because there are always outliers included in the averages.
EMH does not say that you can never outperform the market. It says that there are outliers who can beat the market averages. But there are also outliers who lose big to the market. The majority is closer to the median. Those who "win" are lucky; those who "lose" are unlucky.
EMH and Investing Strategies
Proponents of EMH, even in its weak form, often invest in index funds or certain ETFs. That is because those funds are passively managed and simply attempt to match, not beat, overall market returns.
Index investors might say they are going along with this common saying: "If you can't beat 'em, join 'em." Instead of trying to beat the market, they will buy an index fund that invests in the same securities as the benchmark index.
Some investors will still try to beat the market, believing that the movement of stock prices can be predicted, at least to some degree. For that reason, EMH does not align with a day trading strategy. Traders study short-term trends and patterns. Then, they attempt to figure out when to buy and sell based on these patterns. Day traders would reject the strong form of EMH.
For more on EMH, including arguments against it, check out the EMH paper from economist Burton G. Malkiel. Malkiel is also the author of the investing book "A Random Walk Down Main Street." The random walk theory says that movements in stock prices are random.
The Bottom Line
If you believe that you can't predict the stock market, you would most often support the EMH. But a short-term trader might reject the ideas put forth by EMH, because they believe that they are able to predict changes in stock prices.
For most investors, a passive, buy-and-hold, long-term strategy is useful. Capital markets are mostly unpredictable with random up and down movements in price.
Frequently Asked Questions (FAQs)
When did the Efficient Market Hypothesis first emerge?
At the core of EMH is the theory that, in general, even professional traders are unable to beat the market in the long term with fundamental or technical analysis. That idea has roots in the 19th century and the "random walk" stock theory. EMH as a specific title is sometimes attributed to Eugene Fama's 1970 paper "Efficient Capital Markets: A Review of Theory and Empirical Work."
How is the Efficient Market Hypothesis used in the real world?
Investors who utilize EMH in their real-world portfolios are likely to make fewer decisions than investors who use fundamental or technical analysis. They are more likely to simply invest in broad market products, such as S&P 500 and total market funds.