Efficient Market Hypothesis (EMH) (2024)

  • Investment Analysis

Step-by-Step Guide to Understanding the Efficient Market Hypothesis (EMH)

Last Updated February 20, 2024

Learn Online Now

What is the Efficient Market Hypothesis?

The Efficient Market Hypothesis (EMH) theory – introduced by economist Eugene Fama – states that the prevailing asset prices in the market fully reflect all available information.

Efficient Market Hypothesis (EMH) (1)

Table of Contents

  • What is the Definition of Efficient Market Hypothesis?
  • Eugene Fama Quote: Stock Market Theory
  • What are the 3 Forms of Efficient Market Hypothesis?
  • EMH and Passive Investing
  • Efficient Market Hypothesis vs. Active Management
  • Random Walk Theory vs. Efficient Market Hypothesis (EMH)
  • Efficient Market Hypothesis Conclusion

What is the Definition of Efficient Market Hypothesis?

The efficient market hypothesis (EMH) theorizes about the relationship between the:

  • Information Availability in the Market
  • Current Market Trading Prices (i.e. Share Prices of Public Equities)

Under the efficient market hypothesis, following the release of new information/data to the public markets, the prices will adjust instantaneously to reflect the market-determined, “accurate” price.

EMH claims that all available information is already “priced in” – meaning that the assets are priced at their fair value. Therefore, if we assume EMH is true, the implication is that it is practically impossible to outperform the market consistently.

Eugene Fama Quote: Stock Market Theory

“The proposition is that prices reflect all available information, which in simple terms means since prices reflect all available information, there’s no way to beat the market.”

– Eugene Fama

What are the 3 Forms of Efficient Market Hypothesis?

Weak Form, Semi-Strong, and Strong Form Market Efficiency

Eugene Fama classified market efficiency into three distinct forms:

  1. Weak Form EMH: All past information like historical trading prices and volume data is reflected in the market prices.
  2. Semi-Strong EMH: All publicly available information is reflected in the current market prices.
  3. Strong Form EMH: All public and private information, inclusive of insider information, is reflected in market prices.

The Wharton Online
& Wall Street Prep
Buy-Side Investing Certificate Program

Fast track your career as a hedge fund or equity research professional. Enrollment is open for the Sep. 9 - Nov. 10 cohort.

Enroll Today

EMH and Passive Investing

Broadly put, there are two approaches to investing:

  1. Active Management: Reliance on the personal judgment, analytical research, and financial models of investment professionals to manage a portfolio of securities (e.g. hedge funds).
  2. Passive Investing: “Hands-off,” buy-and-hold portfolio investment strategy with long-term holding periods, with minimal portfolio adjustments.

As EMH has grown in widespread acceptance, passive investing has become more common, especially for retail investors (i.e. non-institutions).

Index investing is perhaps the most common form of passive investing, whereby investors seek to replicate and hold a security that tracks market indices.

In recent times, some of the main beneficiaries of the shift from active management to passive investing have been index funds such as:

  • Mutual Funds
  • Exchange-Traded Funds (ETFs)

The widely held belief among passive investors is that it’s very difficult to beat the market, and attempting to do so would be futile.

Plus, passive investing is more convenient for the everyday investor to participate in the markets – with the added benefit of being able to avoid high fees charged by active managers.

Efficient Market Hypothesis vs. Active Management

Long story short, hedge fund professionals struggle to “beat the market” despite spending the entirety of their time researching these stocks with more data access than most retail investors.

With that said, it seems like the odds are stacked against retail investors, who invest with fewer resources, information (e.g. reports), and time.

One could make the argument that hedge funds are not actually intended to outperform the market (i.e. generate alpha), but to generate stable, low returns regardless of market conditions – as implied by the term “hedge” in the name.

However, considering the long-term horizon of passive investing, the urgency of receiving high returns on behalf of limited partners (LPs) is not a relevant factor for passive investors.

Typically, passive investors invest in market indices tracking products with the understanding that the market could crash, but patience pays off over time (or the investor can also purchase more – i.e. a practice known as “dollar-cost averaging”, or DCA).

Random Walk Theory vs. Efficient Market Hypothesis (EMH)

1. Random Walk Theory

The “random walk theory” arrives at the conclusion that attempting to predict and profit from share price movements is futile.

According to the random walk theory, share price movements are driven by random, unpredictable events – which nobody, regardless of their credentials, can accurately predict.

For the most part, the accuracy of predictions and past successes are more so due to chance as opposed to actual skill.

2. Efficient Market Hypothesis (EMH)

By contrast, EMH theorizes that asset prices, to some extent, accurately reflect all the information available in the market.

Under EMH, a company’s share price can neither be undervalued nor overvalued, as the shares are trading precisely where they should be given the “efficient” market structure (i.e. are priced at their fair value on exchanges).

In particular, if the EMH is strong-form efficient, there is essentially no point in active management, especially considering the mounting fees.

Efficient Market Hypothesis Conclusion

Since EMH contends that the current market prices reflect all information, attempts to outperform the market by finding mispriced securities or accurately timing the performance of a certain asset class come down to “luck” as opposed to skill.

One important distinction is that EMH refers specifically to long-term performance – therefore, if a fund achieves “above-market” returns – that does NOT invalidate the EMH theory.

In fact, most EMH proponents agree that outperforming the market is certainly plausible, but these occurrences are infrequent over the long term and not worth the short-term effort (and active management fees).

Thereby, EMH supports the notion that it is NOT feasible to consistently generate returns in excess of the market over the long term.

Most Popular

  • 100+ Excel Financial Modeling Shortcuts You Need to Know
  • The Ultimate Guide to Financial Modeling Best Practices and Conventions
  • What is Investment Banking?
  • Essential Reading for your Investment Banking Interview



Inline Feedbacks

View all comments

Efficient Market Hypothesis (EMH) (2024)


What is meant by efficient market hypothesis? ›

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.

What are the 3 assumptions of EMH? ›

The central assumptions of the EMH that do not hold and which create the most opportunity for business lawyers to add value may be characterized as follows: (a) there are no transaction costs; (b) all information is costlessly available to all investors; and (c) investors have hom*ogeneous expectations.

What does the efficient markets hypothesis implies that? ›

The Efficient Markets Hypothesis (EMH): The contention that, at each time t, the current prices of financial assets reflect all available information relevant for judging the future returns of those assets.

What are the three forms of the efficient market hypothesis? ›

The EMH exists in three forms: weak, semi-strong and strong, and it evaluates the influence of MNPI on market prices. EMH contends that since markets are efficient and current prices reflect all information, attempts to outperform the market are subject to chance not skill.

What is the significance of EMH? ›

The EMH provides the basic logic for modern risk-based theories of asset prices, and frameworks such as consumption-based asset pricing and intermediary asset pricing can be thought of as the combination of a model of risk with the EMH.

What does the efficient market hypothesis predict? ›

The efficient market hypothesis implies that asset prices should be at their fundamental value, which is intrinsically difficult to measure for most classes of assets. It is, however, far simpler to observe in the case of closed-end funds.

What is the argument for EMH? ›

The efficient markets hypothesis (EMH) argues that markets are efficient, leaving no room to make excess profits by investing since everything is already fairly and accurately priced.

What is the problem with EMH? ›

The limitations of EMH include overconfidence, overreaction, representative bias, and information bias.

What is the strong form efficient market hypothesis? ›

The strong form version of the efficient market hypothesis states that all information—both the information available to the public and any information not publicly known—is completely accounted for in current stock prices, and there is no type of information that can give an investor an advantage on the market.

What is the main insight of the efficient market hypothesis? ›

Although you might get lucky once or twice, the efficient market hypothesis suggests that you cannot consistently outperform the market average when it comes to investment returns. Investors therefore have to make decisions through speculation, which has great risks.

Why is the efficient market hypothesis wrong? ›

Therefore, one argument against the EMH points out that since investors value stocks differently, it is impossible to determine what a stock should be worth in an efficient market. Proponents of the EMH conclude investors may profit from investing in a low-cost, passive portfolio.

What does the efficient market hypothesis support? ›

One of the most famous pieces of evidence supporting the EMH is the random walk theory. This theory suggests that stock price changes are random and unpredictable. In other words, past price movements can't help you predict future price movements. This is consistent with the weak form of the EMH.

What is an example of EMH? ›

The efficient market hypothesis also ignores the impact of sentiment on valuations and prices. For example, there's no question that bubbles exist in the stock market and other asset classes. Well-known examples are the dot-com bubble, the real estate bubble of the mid-2000s, and the recent cryptocurrency bubble.

What are the assumptions of EMH? ›

EMH theory assumes that all kinds of market information are reflected in stock prices accurately. However, the weak EHM theory acknowledges that prices may not always incorporate all information perfectly. It acknowledges a real-world situation where some information may not have been made public.

What are the implications of the efficient market hypothesis (EMH)? ›

In short, EMH implies that technical analysis is not valid. The information available from analyzing past prices has already been incorporated in the stock prices. The investor will not be able to earn excess returns.

What is the efficient markets hypothesis in Quizlet? ›

Efficient Market Hypothesis. The theory that holds that an asset's price reflects all relevant information. When new information comes out, the price will change rapidly and accurately to reflect this information. Differences in returns on assets are ALWAYS explained by differences in risk, or a random result.

What is the true efficient market hypothesis? ›

The Efficient Market Hypothesis, or EMH, states that stock prices reflect all available information at any given time, making it impossible for investors to beat the market with any consistency. The famed efficient market hypothesis, or EMH, is widely accepted by academics and modern investors.

What is an efficient market in economics? ›

Market efficiency refers to the degree to which market prices reflect all available, relevant information. If markets are efficient, then all information is already incorporated into prices, and so there is no way to "beat" the market because there are no undervalued or overvalued securities available.

Top Articles
Latest Posts
Article information

Author: Otha Schamberger

Last Updated:

Views: 6212

Rating: 4.4 / 5 (75 voted)

Reviews: 82% of readers found this page helpful

Author information

Name: Otha Schamberger

Birthday: 1999-08-15

Address: Suite 490 606 Hammes Ferry, Carterhaven, IL 62290

Phone: +8557035444877

Job: Forward IT Agent

Hobby: Fishing, Flying, Jewelry making, Digital arts, Sand art, Parkour, tabletop games

Introduction: My name is Otha Schamberger, I am a vast, good, healthy, cheerful, energetic, gorgeous, magnificent person who loves writing and wants to share my knowledge and understanding with you.