The Efficient Market Hypothesis In Simple Terms

Who uses it and for what purpose?

2 people on subway with news and computer
Efficient Market Hypothesis says that yesterday's news is already reflected in today's stock prices. Darrin Klimek / Getty Images

Most proponents of the efficient market hypothesis firmly believe that the financial markets do not allow investors to earn above-average returns without accepting above average risks.1

In other words, followers of the efficient market hypothesis don't believe that $100 bills are lying around for the taking, either by the professional, or the amateur investor.

This comes from a well-known story of a finance professor and a student who come across a $100 bill lying on the ground.

As the student stops to pick it up, the professor says, "Don't bother - it if were really a $100 bill, it wouldn't be there."

Why does the efficient market hypothesis say the markets are efficient?

The efficient market hypothesis says that as new information arises the news is quickly incorporated into the prices of securities. Believers of the efficient market hypothesis say the market is so efficient at instantly incorporating all known information that no amount of analysis can give you an edge over all the millions of other investors who also have access to all of the same information.

The efficient market hypothesis does not necessarily mean that markets are rational, or that they always price assets accurately. In the short run, investments can become over-valued (think tech stocks in 1999, or real estate in 2006) or under-valued (think stock prices in March 2009) based on investor confidence and their willingness to accept risk.

Over long periods of time, however, investment prices will accurately reflect the expected earnings growth of their underlying assets.

Research supporting the efficient market hypothesis shows the evidence is overwhelming that however inconsistent and irregular the behavior of stock prices may be, the market does not create trading opportunities that enable investors to earn extraordinary risk adjusted returns.

How does the efficient market hypothesis affect my investments?

After the Efficient Market Hypothesis was formulated, participation in index funds increased dramatically. After all, if professional investors have no advantage theoretically and do not "beat the market," then, why would anyone pay a higher management fee to them hoping to do better? In an attempt avoid the stock churn mentality, many investors decide it is better to just own "the market" through the index fund. Buying index funds and following something called Modern Portfolio Theory is proposed by many modern financial advisors. The fee reduction allows for greater compounding and a larger investment value over time.

1Much of the data in the description above comes from The Efficient Market Hypothesis and Its Critics by Burton G Malkiel. It is an excellent research paper.