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What is the Efficient Market Hypothesis? Is it possible to beat the market? What are the three forms of the Efficient Market Hypothesis?
According to the Efficient Market Hypothesis, all share prices reflect all available information. As a result, it’s not possible for anyone (without inside information) to determine whether a stock is valued correctly. There are three forms of the Efficient Market Hypothesis, with each coming to a different conclusion about the efficiency of the market.
Learn more about this hypothesis below.
The Efficient Market Hypothesis: Are Markets Efficient?
One of the dominant theories of finance is that markets are “efficient”—that is, asset prices always already reflect all available information about the assets. In effect, the efficient-markets theory means no investor can “beat” the market, because no investor can gain an “edge” on any other.
The Internet and housing bubbles would appear to refute the efficient-markets hypothesis—because the stock and real-estate markets were absurdly overvalued during the booms, their prices clearly didn’t reflect all available information about their assets.
But, in fact, it’s the crashes that prove markets are efficient. Prices eventually, albeit slowly, reflected the true value of the assets. The market corrected itself.
Can You Beat the Market?
At its most basic level, the Efficient Market Hypothesis, formulated in detail by Nobel Prize-winning economist Eugene Fama, theorizes that all stock prices already reflect all relevant information—that is, no analyst can determine whether a stock is under- or overvalued.
(A common misconception about the Efficient Market Hypothesis is that it means that stock prices are always “correct.” Rather, the hypothesis simply means that stock prices always already reflect everything there is to know about a particular firm.)
In practical terms, what this means is that there’s no way for an analyst to “beat the market,” because any information an individual analyst might use to “buy low” or “sell high” is always already reflected in the current price. For example, a fundamental analyst looking at companies’ balance sheets and management teams will never find either an under- or overvalued stock—the prices will always reflect the stocks’ value as entailed by the available information about them.
However, since the formulation of the theory, scholars have distinguished among three forms of the Efficient Market Hypothesis in order to better characterize analysts’ performance. The forms are:
- The “strong” form, according to which no information whatsoever, including “insider” information, can benefit an analyst
- The “semi-strong” form, according to which no public information can benefit an analyst (though “insider” information might)
- The “weak” form, according to which technical analysis—in other words, the study of past prices—cannot benefit analysts (though fundamental analysis might)
Understanding the three forms of the Efficient Market Hypothesis will help you to better understand the arguments of experts. Economist Burton Malkiel concedes that insider information can benefit analysts (at least in the short run)—but, of course, insider trading is illegal. The consensus among scholars is that the “semi-strong” form of the Efficient Market Hypothesis holds true: that, in the long run, investors are always better off putting their money in a passively managed index fund. Even Benjamin Graham, whose Security Analysis is the bible of fundamental analysis, confessed shortly before he died to agreeing with the Efficient Market Hypothesis.
Exercise: Reflect on the Efficient Market Hypothesis
Consider how security analysis and the Efficient Market Hypothesis affects you.
- If you’re an investor, which theory of security analysis—technical or fundamental—best describes your own process of picking stocks? If you haven’t invested before, which seems more useful to you?
- What is the efficient market hypothesis? How might it affect which method of security analysis you decide to use?
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