The efficient market hypothesis (EMH), as a whole, theorizes that the market is generally efficient, but the theory is offered in three different versions: weak, semi-strong, and strong.
The basic efficient market hypothesis posits that the market cannot be beaten because it incorporates all important determining information into current share prices. Therefore, stocks trade at the fairest value, meaning that they can't be purchased undervalued or sold overvalued.
The theory determines that the only opportunity investors have to gain higher returns on their investments is through purely speculative investments that pose a substantial risk.
Key Takeaways
- The efficient market hypothesis posits that the market cannot be beaten because it incorporates all important information into current share prices, so stocks trade at the fairest value.
- Though the efficient market hypothesis theorizes the market is generally efficient, the theory is offered in three different versions: weak, semi-strong, and strong.
- The weak form suggests today’s stock prices reflect all the data of past prices and that no form of technical analysis can aid investors.
- The semi-strong form submits that because public information is part of a stock's current price, investors cannot utilize either technical or fundamental analysis, though information not available to the public can help investors.
- The strong form version states that all information, public and not public, is completely accounted for in current stock prices, and no type of information can give an investor an advantage on the market.
Weak Form
The three versions of the efficient market hypothesis are varying degrees of the same basic theory. The weak form suggests that today’s stock prices reflect all the data of past prices and that no form of technical analysis can be effectively utilized to aid investors in making trading decisions.
Advocates for the weak form efficiency theory believe that if the fundamental analysis is used, undervalued and overvalued stocks can be determined, and investors can research companies' financial statements to increase their chances of making higher-than-market-average profits.
Semi-Strong Form
The semi-strong form efficiency theory follows the belief that because all information that is public is used in the calculation of a stock's current price, investors cannot utilize either technical or fundamental analysis to gain higher returns in the market.
Those who subscribe to this version of the theory believe that only information that is not readily available to the public can help investors boost their returns to a performance level above that of the general market.
Strong Form
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.
Advocates for this degree of the theory suggest that investors cannot make returns on investments that exceed normal market returns, regardless of information retrieved or research conducted.
Anomalies
There are anomalies that the efficient market theory cannot explain and that may even flatly contradict the theory. For example, the price/earnings(P/E) ratio shows that firms trading at lower P/E multiples are often responsible for generating higher returns.
The neglected firm effect suggests that companies that are not covered extensively by market analysts are sometimes priced incorrectly in relation to their true value and offer investors the opportunity to pick stocks with hidden potential. The January effect shows historical evidence that stock prices—especially smaller cap stocks—tend to experience an upsurge in January.
Though the efficient market hypothesis is an important pillar of modern financial theories and has a large backing, primarily in the academic community, it also has a large number of critics. The theory remains controversial, and investors continue attempting to outperform market averages with their stock selections.
Due to the empirical presence of market anomalies and information asymmetries, many practitioners do not believe that the efficient markets hypothesis holds in reality, except, perhaps, in the weak form.
What Is the Importance of the Efficient Market Hypothesis?
The efficient market hypothesis (EMH) is important because it implies that free markets are able to optimally allocate and distribute goods, services, capital, or labor (depending on what the market is for), without the need for central planning, oversight, or government authority. The EMH suggests that prices reflect all available information and represent an equilibrium between supply (sellers/producers) and demand (buyers/consumers). One important implication is that it is impossible to "beat the market" since there are no abnormal profit opportunities in an efficient market.
What Are the 3 Forms of Market Efficiency?
The EMH has three forms. The strong form assumes that all past and current information in a market, whether public or private, is accounted for in prices. The semi-strong form assumes that only publicly-available information is incorporated into prices, but privately-held information may not be. The weak form concedes that markets tend to be efficient but anomalies can and do occur, which can be exploited (which tends to remove the anomaly, restoring efficiency via arbitrage). In reality, only the weak form is thought to exist in most markets, if any.
How Would You Know If the Market Is Semi-Strong Form Efficient?
To test the semi-strong version of the EMH, one can see if a stock's price gaps up or down when previously private news is released. For instance, a proposed merger or dismal earnings announcement would be known by insiders but not the public. Therefore, this information is not correctly priced into the shares until it is made available. At that point, the stock may jump or slump, depending on the nature of the news, as investors and traders incorporate this new information.
The Bottom Line
The efficient market hypothesis exists in degrees, but each degree argues that financial markets are already too efficient for investors to consistently beat them. The idea is that the volume of activity within markets is so high that the value of resulting prices are as fair as can be. The weak form of the theory is the most lenient and concedes that there are circ*mstance when fundamental analysis can help investors find value. The strong form of the theory is the least lenient in this regard, while the semi-strong form of the theory holds a middle ground between the two.
