Efficient Markets Hypothesis (EMH)

EMH Definition and Forms

investor analyzing stocks - EMH
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The Efficient Market Hypothesis, known as EMH in the investment community, is one of the underlying reasons investors may choose a passive investing strategy. Although fans of index funds may not know it, EMH helps to explain the valid rationale of buying these passive mutual funds and exchange-traded funds (ETFs).

Efficient Market Hypothesis (EMH) Definition

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. Therefore, assuming this is true, no amount of analysis can give an investor an edge over other investors, collectively known as "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 in that direction as well, even if there isn't a rational reason for doing so.

Defining the Forms of EMH

There are three forms of EMH: weak, semi-strong, and strong. Here's what each says about the market.

  • Weak Form EMH: Suggests that all past information is priced into securities. Fundamental analysis of securities can provide an investor with information to produce returns above market averages in the short term, but there are no "patterns" that exist. Therefore, fundamental analysis does not provide long-term advantage and technical analysis will not work.
  • Semi-Strong Form EMH: Implies that neither fundamental analysis nor technical analysis can provide an advantage for an investor and that new information is instantly priced in to securities.
  • Strong Form EMH. Says that all information, both public and private, is priced into stocks and that no investor can gain advantage over the market as a whole. Strong Form EMH does not say some investors or money managers are incapable of capturing abnormally high returns because that there are always outliers included in the averages.

EMH does not say that no investors can outperform the market; it says that there are outliers that can beat the market averages; however, there are also outliers that dramatically lose to the market. The majority is closer to the median. Those who "win" are lucky and those who "lose" are unlucky.

How Passive and Active Investors Look at EMH

Proponents of EMH, even in its weak form, often invest in index funds or certain ETFs because they are passively managed (these funds simply attempt to match, not beat, overall market returns). Index investors might say they are adhering to the 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 underlying benchmark index.

Some investors will still try to beat the market averages, believing that the movement of stock prices can be predicted, at least to some degree. For this reason, EMH does not align with a technical trading (aka day trading) strategy. This is because technical traders study short-term trends and patterns and attempt to detect buying and selling opportunities based upon these patterns. Traders would definitely reject the strong form of EMH.

EMH and Random Walk Theory

For more on EMH, including arguments against it, see this Efficient Market Hypothesis paper from legendary economist Burton G. Malkiel, author of the investing book, "A Random Walk Down Main Street." This book supports the Random Walk Theory of investing, which says that movements in stock prices are random and cannot be accurately predicted.

Bottom Line

If you believe that the stock market is unpredictable with random movements in price up and down, you would generally support the efficient market hypothesis. However, a short-term trader might reject the ideas put forth from EMH because they believe that an investor can predict movements in stock prices.

For most investors, a passive, buy-and-hold, long-term strategy is appropriate because capital markets are mostly unpredictable with random movements in price up and down.

Disclaimer: The information on this site is provided for discussion purposes only, and should not be misconstrued as investment advice. Under no circumstances does this information represent a recommendation to buy or sell securities.