The Efficient Market Hypothesis for Newbie Investors

The Efficient Market Hypothesis (EMH) states that both technical and fundamental market analysts can’t use new information to generate superior returns in the stock market. It supports the notion that when new information is available, equity prices immediately reflect it before anyone can exclusively benefit from it.

Technical analysts use past stock prices to try and predict future price movements. But fundamental analysts study financial information to predict future market movements. Both do not benefit from new information in an efficient market.

Background to the EMH

The Efficient Markets Hypothesis is an investment theory that dates back to the 1970s. It is derived from Eugene Fama’s concepts in his 1970 book, “Efficient Capital Markets: A Review of Theory and Empirical Work.” He pointed out that it is virtually impossible to consistently “beat the market” in the book. He said no manager or investor could make investment returns that outperform the overall market average as reflected by major stock indexes such as the S&P 500 in the United States, the JSE All Share in South Africa, the EGX 30 in Egypt, and the FTSE 100 in the United Kingdom.

This means that no trader or manager should benefit from the information that is not yet made public. If it happens, it defeats the purpose of an efficient market. When traders benefit from the information that is not yet published, it is called insider trading and is punishable by law.

The Efficient Market Hypothesis is supported by several assumptions about the stock market and how it works. One such assumption is that information about stock prices is free and widely available to all investors. Therefore, given the enormous number of traders, information moves efficiently. Since stock price information moves promptly, stocks are traded at their fairest prices.

For this reason, the EMH concludes that since stocks always trade at their fair market value, then it is virtually impossible to either buy undervalued stocks at a bargain or sell overvalued stocks for extra profits.

Forms of the Efficient Market Hypothesis

There are three forms of the Efficient Market Hypothesis. These are the Weak Form of the EMH, the Semi-Strong Form, and the Strong Form of the EMH.

The Weak Form

This form claims all past market prices and data are fully reflected in the stock prices. But new information may not have been fully reflected. This form does not favor technical analysts because if past market prices are already reflected in stock prices, they will not be able to produce excess returns consistently. However, some fundamental analysts may still provide excess returns in the weak form of the Efficient Market Hypothesis.

The Semi-Strong Form

This form states that all the publicly available information is fully reflected in stock prices. With this form, neither technical nor fundamental analysts can produce excess returns. Neither of them has the power to predict price movements. Prices in this form are assumed to quickly absorb new information and move accordingly. For example, when the European authorities report a significant shrink in the GDP, you can see prices quickly moving as the market absorbs new information.

The Strong Form

The strong form of the Efficient Market Hypothesis asserts that all information, be it public or private, is fully reflected in stock prices. This form assumes that even insider information or material non-public information cannot be used to beat market returns.

Supporters and opponents of the Efficient Market Hypothesis

Can markets be efficient?

Indeed, markets are efficient (even though some may not be, especially the smaller ones with fewer buyers and sellers). But investors, across the world, are happy to pay what they believe is a fair price for assets. No one has an information monopoly over the others, even though active managers or technical analysts believe they have an edge and can always generate alpha (outperforming market benchmark indices).

Nevertheless, a study by Morningstar, carried out between 2009 and 2019, compared returns from active managers (technical analysts) with those from index funds and Exchange Traded Funds. The study found that only 23% of active managers beat passive managers (ETFs and index funds). But, had the market not been efficient, active managers would beat index funds and ETFs hands down. They are formed to beat the indices that passive managers track, and this study showed they could not beat them entirely over the 10 years. Therefore, because the market is efficient, some investors are told that they can enjoy more returns if they invest in low-cost passive funds than pay high fees to active managers who struggle to beat the market.

Arguments against the EMH

Challenges with the Efficient Market Hypothesis are that some investors and traders keep beating the market each year even though this is not supposed to be possible.

More so, there are usually more than average returns from small to medium stocks. These can just outperform the market without considering the availability of new information. There are also generally times of the year that the stock market performs better, for example, the January effect. Finally, the strong form of the EMH states that even insider information cannot beat the market. But insider traders have often been arrested for making unfair gains by taking positions that will benefit them once certain information about a company comes out.

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