Efficient market hypothesis or EMH is an investment theory which suggests that the prices of financial instruments reflect all available market information. Hence, investors cannot have an edge over each other by analysing the stocks and adopting different market timing strategies. According to this theory developed by Eugene Fama, investors can only earn high returns by taking more significant risks in the market.
Also referred to as an efficient market theory, EMH is based on the following assumptions –
EMH has three variations which constitute different market efficiency levels. They are discussed below –
This is based on the assumption that the market prices of all financial instruments represent all public information related to the market. It does not reflect any information that is not yet disclosed publicly. Moreover, the efficient market hypothesis assumes that historical data like price and returns have no relation with the future price of a financial instrument.
This variation EMH also suggests that different strategies implemented by traders cannot fetch consistent returns. This is owing to the assumption that historical price points cannot predict future market value. Although this form of EMH dismisses the concept of technical analysis, it provides the opportunity for fundamental analysis. This helps all market participants to find out more information and earn an above-average return on investment.
This version of EMH elaborates on the assumptions of the weak form and accepts that the market prices make quick adjustments in response to any new public information that is disclosed. Hence, there is no scope for both technical and fundamental analysis.
This form of EMH states that the market prices of securities represent both historical and current information. This includes insider information as well as publicly disclosed information. It also suggests that the price reflects information available only to board members or the CEO of a company.
EMH is gradually gathering popularity among traders. Market participants who advocate this theory usually tend to invest in index funds and exchange-traded funds (ETFs) which are more passive in nature. This is one of the main advantages of the efficient market hypothesis.
These traders are reluctant to pay the high charges imposed by the experienced fund managers as they don’t even rely on the experts to outperform the market. However, recent data suggests that there are a few fund managers who have been consistent in beating the market.
Since its first implementation in the 1960s, many limitations of EMH have gradually emerged. They are discussed in detail below –
Speculative bubbles tend to arise when the price of a financial instrument rises above its fair market value and reaches a point where market corrections take place. During this situation, prices begin to fall rapidly, which leads to a market crash.
But EMA suggests that both financial crashes and market bubbles should not arise. As a matter of fact, this theory completely dismisses their existence.
Market anomalies refer to a situation where there is a difference between the trajectory of a market price as established by the efficient market hypothesis and its behaviour in reality. Market anomalies may arise anytime for no particular reason. This proves that financial markets do not remain efficient at all times.
There are many investors who have consistently outperformed the market. They do not subscribe to the suggestions of EMH and have been vocal in criticising the same for its passive approach.
Behavioural economics dismisses the idea that all market participants are rational individuals. It also suggests that difficult circumstances may put stress on individuals, forcing them to make irrational decisions. Thus, due to social pressure, traders may also commit major errors and undertake unwarranted risks. Also, the herding phenomenon plays a vital role in elucidating behavioural aspects of traders which are not considered by EMH.
Moreover, traders’ decisions may also be influenced by their individual personality traits and emotions.
Generally, traders who feel that the stock market is volatile with rapid fluctuations in the market price, subscribe to the efficient market hypothesis. But traders engaging in short-term trade do not tend to support this hypothesis. Most investors prefer to choose a long-term strategy due to rapid price fluctuations in the stock market.