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.

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 say the market is so efficient at instantly incorporating all known information that no amount of analysis can provide an edge over all the millions of other investors who also have access to all of the same information.

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.

If it's impossible to beat the market, why do so many people try?

According to one report, only about 10% of trading volume in stocks comes from "fundamental discretionary traders" and another 60% comes from passive and quantitative investing but a quick look through the many funds on the market plenty of products trying to prove the efficient market hypothesis wrong.

Opponents of the theory ask, why the market remain so mispriced for so many years following the recent recession? Sure, in the short-run it may have been mispriced but for that many years? 

One idea is that the market is "efficiently inefficient." The average investor won't be able to beat the market but if a massive bank throws enough money and computer power into the effort, they will find success. This theory is why computerized trading came to dominate the market.

Proponents of efficient market hypothesis would say that the examples above are simply payment for risk. The real estate investor who purchased property at the low of the 2009 recession made a handsome profit because of the risk they took on.

The high frequency trader has no idea if the stock will be up or down in a matter of minutes or hours so their level of risk is high. If they make money, it's payment for increased risk.

Also, 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.

Efficient market hypothesis has been the subject of debate among the investing academia since its debut in the 1960s. All data points to the fact that investing for the long term is a more profitable strategy then trying to cash in quickly.

That along might indicate that there's more to efficient market hypothesis than the naysayers want to let on.