EMH Theory (Efficient Market Hypothesis): Know it All Now (2024)

EMH theory is a highly disputed and controversial theory in modern financial economics.

The full form of EMH theory is the Efficient Market Hypothesis. The proponents of the EMH theory believe that outsized risk-adjusted returns can be achieved only if investors rely on speculation or gather inside information.

Before learning about the efficient market hypothesis assumptions, types, and strategies, let’s check what EMH theory is.

What is EMH theory?

EMH theory is an important modern financial theory. An economist named economist Eugene Fama was the first person to formulate it in the late 1960s.

It hypothesises that generally markets function in an efficient manner and stocks always trade at their fair values on stock exchanges. This means all available information gets reflected in stock prices.

According to this theory, fundamental analysis and technical analysis cannot provide you with higher returns. The proponents believe that no investor or trader can buy undervalued stocks or sell overvalued stocks. This is mainly because EMH theory believes that all stocks trade at their fairest value only.

According to the Efficient Market Hypothesis theory, no investor can outperform the market until and unless they have insider information. Theoretically, investors may also beat market returns if they make speculative investments, which is very risky.

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Efficient Market Hypothesis theory: How does it work?

According to the EMH theory, the current prices of a stock incorporate all kinds of available information.

When new information is revealed, the prices adjust themselves quickly to accommodate it. That’s why, as per the Efficient Market Hypothesis theory, it is almost impossible for any investor to outperform the market consistently on a risk-adjusted basis.

Top 5 efficient market hypothesis assumptions

There are five major assumptions in EMH theory. Let us check them closely.

1. All market players have perfect information and the market is efficient
   All market participants are assumed to have all kinds of information regarding a stock. The theory also assumes that information is free and that all new information is available to all market players instantly. At a certain point in time, all available information is reflected in the prices of stocks.
2. Investors are rational
   All investors are assumed to be rational decision-makers. Their sole aim is the maximization of their utility. FOMO or others don’t affect their decision-making capabilities. They are assumed to make decisions logically to maximise their utilities.
3. Zero transaction cost
   EMH theory assumes that a trader or investor doesn’t have to pay any transaction cost (fee and tax) for buying or selling stocks.
4. Frictions in the market are absent
   In the real world, many market restrictions can be seen. Some of the most common restrictions are trading impediments, borrowing constraints, short selling, and many more. However, the efficient market hypothesis assumes that the market is efficient and all market players can take any position freely and without any restriction.
5. Prices are determined randomly
   The EMH theory believes that studying stock price patterns in the past can’t be used to predict any future price movement. This is because the theory hypothesises that stock prices are determined randomly. That’s why technical analysis to predict future prices is considered futile as per the efficient market hypothesis.

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What are the different types of EMH theory?

There are 3 types of efficient market hypothesis:

1. Weak EHM
   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. The weak EHM theory believes that new information made available to the public influences pricing. However, WEHM believes that historical prices don’t affect current or future prices. That’s why it also considers technical analysis ineffective.
2. Semi-Strong EMH
   According to this theory, new public information makes stock prices adjust quickly. It believes that neither fundamental nor technical analysis can provide investors with abnormally high profits.
3. Strong EMH
   The strong efficient market hypothesis proposes that a stock price incorporates all possible information (whether public or private). It believes that investors having confidential information cannot make make profit from sudden fluctuations in stock prices. This is because the market has already incorporated all relevant data.

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Final words

The proponents of the efficient market hypothesis (EHM) theory say that in the long run, most investors will get a return that is similar to the market performance. However, detractors say that the EHM proponents don’t consider the active investing scenario where investors can continuously include better-performing stocks in their portfolio to outperform the market. Most proponents of EHM theory suggest investors buy and hold stocks for the long term to gain profit, which is the same return as the market.

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