Efficient Market Hypothesis
In full disclosure, my personal views of the market are anything but efficient. However, investors have been pushing the idea of the efficient market hypothesis for many years, so here is my explanation of what it is and how it is supposed to work.
Understanding the Efficient Market Hypothesis
As stock investors, it’s crucial for us to grasp the Efficient Market Hypothesis (EMH), which is often used to make investment decisions. Here, we’ll clarify what it is, its varying forms, and how the Random Walk Theory ties into market efficiency.
Definition and Fundamentals
The Efficient Market Hypothesis posits that stock prices reflect all available information, meaning current share prices always incorporate and reflect all relevant data.
This indicates that we, as investors, cannot achieve consistently higher returns without accepting additional risk since price changes only arise due to new information, which is, by its nature, random and unpredictable.
Forms of Market Efficiency
Market efficiency is categorized into three forms:
- Weak-Form Efficiency: Stock prices reflect all past trading information. Under this form, technical analysis is of little to no value.
- Semi-Strong Form Efficiency: Prices not only reflect historical data but also all publicly available information. It implies that fundamental analysis is also ineffective.
- Strong-Form Efficiency: This form assumes stock prices account for all information, both public and private, making even insider information useless in predicting stock price movements.
Here’s a simple table that sums up these forms:
| Form | Information Included | Implications for Analysis |
|---|---|---|
| Weak-Form | Past prices, volume | Technical analysis ineffective |
| Semi-Strong Form | All public information | Fundamental analysis ineffective |
| Strong-Form | All public and private information | No advantage even with insider info |
Random Walk Theory and Its Relevance
The Random Walk Theory is closely associated with EMH and proposes that stock prices fluctuate randomly, so their past movement cannot predict their future performance.
Since information flows randomly and at unpredictable times, we can understand why it is so challenging to consistently outperform the market.
This theory underpins many of the arguments used to support passive portfolio management strategies when adhering to the principles of EMH.