Efficient Market Hypothesis

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Description of the Efficient Market Hypothesis. Explanation.


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Efficient Market Hypothesis or Investor Sentiment?

Definition Efficient Market Hypothesis. Description

Efficient Market Hypothesis (EMH) states stock market prices reflect the knowledge and expectations of all investors at any given point in time.

In other words, financial markets are considered "informationally efficient": because all information is publicly available at the time an investment is made.

Because of this, one cannot consistently achieve Abnormal Returns in excess of average market returns on a risk-adjusted basis.

Investors who follow this theory consider it futile to forecast stock price movements using financial statements or to search for undervalued or overvalued stocks, as any new development is quickly reflected in an organization's stock price.

EMH theory does not entirely preclude the use of financial statements for investment decisions, as financial information about an organization can still have value for predicting the degree to which the stock price moves up or down with market wide stock price movements, even if markets are efficient.

Basis of Portfolio Theory and CAPM

The Efficient Market Hypothesis is the basis of 2 major capital asset pricing models: The Portfolio Theory by Harry Markowitz and the Capital Asset Pricing Model by William Sharpe.

Weak EMH, Semi-strong EMH, and Strong EMH

In fact there are 3 versions of the hypothesis: "weak", "semi-strong", and "strong".

  • The Weak Efficient Market Hypothesis argues that future share prices cannot be predicted by analyzing prices from the past. So prices of traded assets (e.g., stocks, Bonds, Index Funds, Mutual Funds, etc.) already reflect all past publicly available information.
  • The Semi-strong Efficient Market Hypothesis claims share prices adjust to publicly available new information very rapidly and in an unbiased fashion, such that no excess returns can be earned by trading on that information. So prices of traded assets reflect all publicly available information and prices instantly change to reflect new public information.
  • The Strong Efficient Market Hypothesis additionally claims that share prices reflect all information, public and private, and no one can earn excess returns. So prices of traded assets instantly reflect even hidden or "insider" information.

Critics of Efficient Market Hypothesis

The EMH disregards the field of Behavioral Finance and phenomena such as Cognitive Bias, Bounded Rationality and Groupthink / Investor Sentiment. Speculative bubbles are obviously also contradicting EMH theory. According to some theorists the widespread belief in EMH was actually the main reason why the economic crisis of 2007 occurred.

Compare also with: Systemic Risk  |  Capital Assets Pricing Model  |  Fundamental Analysis  |  Technical Analysis  |  Quantitative Investment Analysis  |  Buy-Side Analyst  |  Sell-Side Analyst 

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Efficient Market Hypothesis Special Interest Group

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Best Practices - Efficient Market Hypothesis Premium

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Introduction to Capital Market Efficiency: Portfolio Theory and CAPMSign up

This presentation provides insights into capital m...
Usage (application): CAPM, Portfolio Theory, Efficient Markets Hypothesis, Risk and Expected Return, Investing, Financial Asset Valuation

Efficient Markets and Behavioral Financial Decision MakingSign up

This presentation elaborates on financial decision...
Usage (application): Behavioral Finance, Rational Decision-making, CAPM

Interview Sharpe: Background CAPMSign up

Short interview with Nobel Prize-winning economist...
Usage (application): Understanding Two Basic Elements behind CAPM

Value Premium and CAPMSign up

Eugene F. Kama and Kenneth R. French examine:
Usage (application): Value Premium Analysis

Giving Financial Advice on Dealing with UncertaintySign up

Harry Markowitz gives short answers two questions:...
Usage (application): Financial Services, Asset Management, Financial Investing

Interview W. Blake: Golden Rules of InvestingSign up

William Blake gives 2 golden rules on investing: Usage (application): Advanced Implementation of Investing

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