efficient markets hypothesis arguments

What Is the Efficient Market Hypothesis?

Updated: May 11, 2022, 1:05pm

The efficient market hypothesis argues that current stock prices reflect all existing available information, making them fairly valued as they are presently. Given these assumptions, outperforming the market by stock picking or market timing is highly unlikely, unless you are an outlier who is either very lucky or very unlucky.

Understanding the Efficient Market Hypothesis

The most important assumption underlying the efficient market hypothesis is that all information relevant to stock prices is freely available and shared with all market participants.

Given the vast numbers of buyers and sellers in the market, information and data is incorporated quickly, and price movements reflect this. As a result, the theory argues that stocks always trade at their fair market value.

Followers of the efficient market hypothesis believe that if stocks always trade at their fair market value, then no level of analysis or market timing strategy will yield opportunities for outperformance.

In other words, an investor following the efficient market hypothesis shouldn’t buy undervalued stocks at bargain basement prices expecting to see large gains in the future, nor would they benefit from selling overvalued stocks.

The efficient market hypothesis begins with Eugene Fama, a University of Chicago professor and Nobel Prize winner who is regarded as the father of modern finance. In 1970, Fama published “Efficient Capital Markets: A Review of Theory and Empirical Work,” which outlined his vision of the theory.

Three Variations Of the Efficient Market Hypothesis

Investors who strongly believe in the efficient market hypothesis choose passive investment strategies that mirror benchmark performance, but they may do so to varying degrees. There are three main variations on the theory:

1. The Weak Form of the Efficient Market Hypothesis

Although investors abiding by the efficient market hypothesis believe that security prices reflect all available public market information, those following the weak form of the hypothesis assume that prices might not reflect new information that hasn’t yet been made available to the public.

It also assumes that past prices do not influence future prices, which will instead be informed by new information. If this is the case, then technical analysis is a fruitless endeavor.

The weak form of the efficient market hypothesis leaves room for a talented fundamental analyst to pick stocks that outperform in the short-term, based on their ability to predict what new information might influence prices.

2. The Semi-Strong Form of the Efficient Market Hypothesis

This form takes the same assertions of weak form, and includes the assumption that all new public information is instantly priced into the market. In this way, neither fundamental nor technical analysis can be used to generate excess returns.

3. The Strong Form of the Efficient Market Hypothesis

Strong form efficient market hypothesis followers believe that all information, both public and private, is incorporated into a security’s current price. In this way, not even insider information can give investors an opportunity for excess returns.

Arguments For and Against the Efficient Market Hypothesis

Investors who follow the efficient market hypothesis tend to stick with passive investing options, like index funds and exchange-traded funds ( ETFs ) that track benchmark indexes, for the reasons listed above.

Given the variety of investing strategies people deploy, it’s clear that not everyone believes the efficient market hypothesis to be a solid blueprint for smart investing. In fact, the investment market is teeming with mutual funds and other funds that employ active management with the goal of outperforming a benchmark index.

The Case for Active Investing

Active portfolio managers believe that they can leverage their individual skill and experience—often augmented by a team of skilled equity analysts—to exploit market inefficiencies and to generate a return that exceeds the benchmark return.

There is evidence to support both sides of the argument. The Morningstar Active vs Passive Barometer is a twice-yearly report that measures the performance of active managers against their passive peers. Nearly 3,500 funds were included in the 2020 analysis, which found that only 49% of actively managed funds outperformed their passive counterparts for the year.

On the other hand, looking at the 10-year period ending December 31, 2020 shows a different picture, since the percentage of active managers who outperformed comparable passive strategies dropped to 23%.

Are Some Markets Less Efficient than Others?

A deeper look into the Morningstar report shows that the success of active or passive management varies considerably according to the type of fund.

For example, active managers of U.S. real estate funds outperformed passively managed vehicles 62.5% of the time, but the figure drops to 25% when fees are considered.

Other areas where active management tends to outperform passive—before fees—include high yield bond funds at 59.5% and diversified emerging market funds at 58.3%. The addition of fees for portfolios that are actively managed tends to drag on their overall performance in most cases.

In other asset classes, passive managers significantly outperformed active managers. U.S. large-cap blend saw active managers outperform passive only 17.2% of the time, with the percentage dropping to 4.1% after fees.

These results seem to suggest that some markets are less efficient than others. Liquidity in emerging markets can be limited, for example, as can transparency. Political and economic uncertainty are more prevalent, and legal complexities and lack of investor protections can also cause problems.

These factors combine to create considerable inefficiencies, which a knowledgeable portfolio manager can exploit.

On the other hand, U.S. markets for large-cap or mid-cap stocks are heavily traded, and information is rapidly incorporated into stock prices. Efficiency is high and, as demonstrated by the Morningstar results, active managers have much less of an edge.

How Star Managers Handle Their Portfolios

Popular investment manager Warren Buffet is one successful example of an active investor. Buffet is a disciple of Benjamin Graham, the father of fundamental analysis, and has been a value investor throughout his career. Berkshire Hathaway, the conglomerate that holds his investments, has earned an annual return of 20% over the past 52 years, often outperforming the S&P 500 .

Another successful public investor, Peter Lynch, managed Fidelity’s Magellan Fund from 1977 to 1990. With his active investment ideology at the helm, the fund returned an average 29% annually and, over the 13-year period, Lynch outperformed the S&P 500 eleven times.

By contrast, another legendary name that stands out in the investment world is Vanguard’s Jack Bogle, the father of indexing. He believed that over the long term, investment managers could not outperform the broad market average, and high fees make such an objective even more difficult to achieve. This belief led him to create the first passively managed index fund for Vanguard in 1976.

The Efficient Market Hypothesis and Other Investment Strategies

Strong belief in the efficient market hypothesis calls into question the strategies pursued by active investors. If markets are truly efficient, investment companies are spending foolishly by richly compensating top fund managers.

The explosive growth in assets under management in index and ETF funds suggests that there are many investors who do believe in some form of the theory.

However, legions of day traders depend on technical analysis. Value managers use fundamental analysis to identify undervalued securities and there are hundreds of value funds in the U.S. alone.

These are only two examples of investors who believe that it is possible to outperform the market. With so many professional investors on each side of the efficient market hypothesis, it’s up to individual investors to weigh the evidence on both sides and to reach a conclusion about the efficiency of the financial markets that best matches their investing beliefs.

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• Introduction

Three forms of efficient-market hypothesis

What the efficient-market hypothesis means for investors, criticisms and limitations, validation on a large scale, the bottom line.

Are markets efficient? How Eugene Fama kicked off a controversy

One of the most controversial topics in finance is the efficient-market hypothesis, developed by Eugene Fama in 1965. In a nutshell, the theory says that the financial markets are efficient, so no one can gain an edge in them.

Fama’s paper “The Behavior of Stock-Market Prices,” which was published in the Journal of Business , doesn’t use the term efficient-market hypothesis. Rather, it says that “… a situation where successive price changes are independent is consistent with the existence of an ‘efficient’ market for securities , that is, a market where, given the available information, actual prices at every point in time represent very good estimates of intrinsic values.”

• The efficient-market hypothesis claims that stock prices contain all information, so there are no benefits to financial analysis.
• The theory has been proven mostly correct, although anomalies exist.
• Index investing, which is justified by the efficient-market hypothesis, has supported the theory.

That line set off a theoretical explosion in university economics departments. At first, Wall Street ignored the idea of market efficiency because it contradicted the work of most analysts and brokers. But the evidence became too strong to ignore, and the efficient-market hypothesis is now generally accepted despite its weaknesses, including the inability at times to determine why the price of an asset has risen or fallen.

But just what is the efficient-market hypothesis? What are its key principles and its implications for investors?

The efficient-market hypothesis says that financial markets are effective in processing and reflecting all available information with little or no waste, making it impossible for investors to consistently outperform the market based on information already known to the public. One area of debate is how strong the efficient-market hypothesis is. In 1970, Fama wrote another paper that explored the idea of market efficiency in more depth, noting that it seemed to take three forms:

• Weak-form efficiency: In this form, market prices reflect all past trading information, such as historical prices and trading volumes. According to weak-form efficiency, technical analysis (the study of past price and volume data) cannot consistently generate excess returns because this information is already reflected in stock prices .
• Semi-strong-form efficiency: This idea says that all publicly available information, including news and past trading data , is fully reflected in stock prices. As a result, neither technical analysis nor fundamental analysis (the study of financial statements and economic factors) can consistently beat the market, because all available information is already incorporated into prices.
• Strong-form efficiency: The most robust version of the efficient-market hypothesis contends that all information, public and private, is fully reflected in stock prices. In other words, no individual or group of investors possesses information that can consistently yield superior returns. This form of efficiency suggests that insider trading is futile in the long run, as insider information is also reflected in stock prices.

The biggest implication of the efficient-market hypothesis is that index funds and other passive investing strategies offer better risk-adjusted returns after fees than active investment. At an extreme, it suggests that doing research and analysis is no better than picking stocks at random.

Study the art of stock picking.

Want to choose stocks that are right for you and become a better investor? Learn about the benefits of diversification .

One assumption in the efficient-market hypothesis is that information is distributed immediately throughout the market. In 1965, that seemed ridiculous and formed one critique of the model, but financial services companies soon realized that speed pays off. The sooner someone could find an anomaly and act on it, the faster they could lock in a profit. Today, brokerages and market makers tie their servers directly to securities exchanges to shave milliseconds from execution times.

Despite its significance, the efficient-market hypothesis is not without criticisms and limitations. Some critics argue that several factors prevent markets from being perfectly efficient, including:

• Behavioral biases —errors in judgment, decision-making, and thinking when evaluating information.
• Information asymmetry —where one person has more or better information than someone else.
• Market frictions —anything that interferes with market transactions, including transaction costs, taxes, regulation, and information glitches.

Naysayers point to market bubbles , crashes , and persistent anomalies as evidence against strong market efficiency. An entire field of finance, behavioral economics , has developed to explore how market participants are inefficient.

Another criticism of the efficient-market hypothesis is that certain valuation anomalies persist, even though the hypothesis says they shouldn’t. One is that small companies tend to outperform larger ones; another is that value stocks tend to outperform those with higher price-to-earnings (P/E) ratios . In 1992, Fama and Kenneth French published a paper showing that those anomalies were real and should be incorporated into financial valuation models.

The efficient-market hypothesis remains a cornerstone of financial theory and has had a profound influence on investment strategies, portfolio management, and the understanding of financial markets. Although its three forms provide an accepted framework for thinking about market efficiency, the debate about its validity continues.

Investors and researchers alike grapple with the ever-evolving nature of financial markets, where the balance between efficiency and inefficiency remains a subject of ongoing study and discussion. Regardless of your stance on the efficient-market hypothesis, it has undeniably shaped how we approach investing and market analysis today.

In 2013, Fama received the Nobel Prize for his work. The market has accepted the efficient-market hypothesis, and index investing has revolutionized the financial industry. One of Fama’s students, David Booth, started an investment company specializing in index investing for institutional clients (such as pension funds and insurance companies). Booth was so successful—and so grateful—that he donated $300 million to the University of Chicago in 2008. In exchange, the university named its business school after him. Talk about a legacy .

• The Behavior of Stock-Market Prices | jstor.org
• Efficient Capital Markets: A Review of Theory and Empirical Work | jstor.org
• Common Risk Factors in the Returns on Stocks and Bonds | sciencedirect.com
• Eugene F. Fama – Facts | nobelprize.org

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Efficient Markets Hypothesis

The efficient market hypothesis (EMH) suggests that financial markets operate in such a way that the prices of equities, or shares in companies, are always efficient.

Elliot currently works as a Private Equity Associate at Greenridge Investment Partners, a middle market fund based in Austin, TX. He was previously an Analyst in  Piper Jaffray 's Leveraged Finance group, working across all industry verticals on  LBOs , acquisition financings, refinancings, and recapitalizations. Prior to Piper Jaffray, he spent 2 years at  Citi  in the Leveraged Finance Credit Portfolio group focused on origination and ongoing credit monitoring of outstanding loans and was also a member of the Columbia recruiting committee for the Investment Banking Division for incoming summer and full-time analysts.

Elliot has a Bachelor of Arts in Business Management from Columbia University.

• What Is The Efficient Market Hypothesis (EMH)?
• Variations Of The Efficient Markets Hypothesis
• Are Capital Markets Efficient?

What Is the Efficient Market Hypothesis (EMH)?

The efficient market hypothesis (EMH) suggests that  financial markets operate in such a way that the prices of equities, or shares in companies, are always efficient. In simpler terms, these prices accurately reflect the true value of the underlying companies they represent.

The efficient market hypothesis is one of the most foundational theories developed in finance. It was developed by Nobel laureate Eugene Fama in the 1960s and is widely known amongst finance professionals in the industry.

There are many implications arising from this hypothesis; however, the main proposition is that it is impossible to “beat the market” and generate alpha. 

What does beating the market or generating alpha mean? Broadly speaking, you can think of how much the return of your risk-adjusted investments exceeds benchmark indices. 

For example, a proxy for the US market will be the S&P 500, which covers the top 500 companies in the United States or over 80% of its total market capitalization .

If your portfolio of investments generated an alpha of 3%, then it is considered that your portfolio outperformed the S&P 500 by 3% (assuming that you trade in the US market)

How is it possible that share prices are always efficient and reflect the actual value of the underlying company following the efficient market hypothesis? 

It is because, at all times, a company's share price reflects certain relevant available information to all investors who trade upon it, and the type of information required to ensure efficient prices depends on what form of efficiency the market is in. 

If you are interested in a profession surrounding capital markets, be it asset management , sales & trading, or even hedge funds, the EMH is a theory you need to know to ace your interviews. 

However, this is only one topic in the diverse world of finance that you will truly need to know if you want to break into these careers. To gain a deeper understanding of finance, look at Wall Street Oasis's courses. For a link to our courses, click  here .

Key Takeaways

• Developed by Eugene Fama, the EMH suggests that financial markets reflect all available information and that it's impossible to consistently "beat the market" to generate abnormal returns (alpha).
• The EMH has three forms: weak, semi-strong, and strong. Each form describes the extent of information already reflected in stock prices.
• Under this form, stock prices incorporate historical information like past earnings and price movements. Investors can't gain alpha by trading on this historical data as it's already "priced in."
•  In this form, stock prices reflect all publicly available information, including recent news and announcements. Even with access to this information, investors can't consistently beat the market.
• The strongest form of EMH incorporates all information, including insider information. Even with insider knowledge, investors can't generate abnormal returns. However, some argue that real-world markets may not fully adhere to this hypothesis due to behavioral biases and inefficiencies.

Variations of the Efficient Markets Hypothesis

According to Eugene Fama, there are three variations of efficient markets:

Semi-strong form 

Strong form 

Depending on which form the market takes, the share price of companies incorporates different types of information. Let’s go over what kind of information is required for each form of the efficient market. 

Weak form efficiency

Under the weak form of efficient markets, share prices incorporate all historical information of stocks. This would typically cover a company’s historical earnings, price movements, technical indicators, etc. 

Another way to look at it is that when a market is weakly efficient, it means - there is no predictive power from historical information. 

Investors are unlikely to generate alpha from investing in a company just because they saw that the company outperformed earnings estimates last week. That information was already “priced in,” and there is nothing to gain trading off that information.

Semi-strong form efficiency 

The semi-strong form of efficiency within markets is believed to be most prevalent across markets. Under this form of efficiency, share prices incorporate all historical information of stocks and go a step further by including all publicly available information. 

This implies that share prices practically adjust immediately following the announcement of relevant information to a company’s stock.

What this means is that investors are not able to generate alpha by trading off relevant information that is publicly available, no matter how recent that piece of information became public.

This partially explains why you’ve probably heard those investment gurus tell you to buy the rumors and sell on the news.

One relevant example would be the reaction from every stock exchange worldwide on specific key dates surrounding the World Health Organization and the Covid-19 pandemic. 

The market crashed following specific announcements because, at that time, the market anticipated lockdowns to occur, which would damage every company’s supply chain and sales. 

If lockdowns did occur, companies wouldn’t be able to produce goods and services. Furthermore, customers wouldn’t be able to purchase goods, resulting in companies taking a hit on their earnings. And this was exactly what happened. 

Although Covid was known since November 2019, If you look at the S&P 500 and the FTSE 100, they both crashed on the same date (21st February 2020), with the impact on markets being equally significant. 

It would be safe to say that this was the date that the market started incorporating the impact of Covid-19 on a company’s share price. It is no coincidence that the World Health Organization also hosted a  press conference  that day. 

You can look at the FTSE 100 and S&P 500 index, which represent the UK and US market conditions. The following images show the drop in benchmark indices due to Covid-19: 

Unfortunately, there are a couple of caveats to this example. 

In Eugene Fama’s  purest  depiction of the semi-strong form of an efficient market hypothesis, prices are meant to adjust instantaneously following the public announcement of relevant information, with the new prices reflecting the market’s new actual value. 

When you look at the market’s reaction to Covid-19, the market crash happened gradually over a certain period. 

Furthermore, if you look at the FTSE 100 and S&P 500, the index started showing signs of recovery immediately after the market crash. 

Broadly speaking, there are two reasons this could have happened: 

There was an announcement of new publicly available information with a positive impact on markets

The market had initially overreacted to the Covid-19 pandemic

An excellent example of newly announced publicly available information with a positive impact on markets would be something like the respective countries’ governments and central banks both promoting aggressive monetary and fiscal policies designed to improve economic situations. 

Although it is impossible to say, and every investor will have a different opinion on the market, the consensus is that the market has reacted to monetary and fiscal policies. As a result, there was an initial overreaction to Covid-19 in the market. 

This is where the practical example strays away from theory. In the market’s reaction to Covid-19, the impact of new information was gradual (but still quick) and argued to be inefficient at the trough. 

However, Eugene Fama’s efficient market hypothesis anticipates rapid price movements following the release of public information, and prices are always efficient, moving from one true value to another. 

Market indices that genuinely follow the semi-strong form efficient market hypothesis would look something like this: 

And this is what the  true  efficient market hypothesis envisions. There is no exaggeration in this graph, and the market index isn't expected to have any daily fluctuation because it reflects the valid, efficient value pricing in all the publicly available information. 

Reaction to new relevant information is instant and accurate, leaving no room for values to readjust over time. 

This example applies to all forms of efficient markets, including the weak and strong forms. However, the difference is the type of information that will cause a company's share price to readjust. 

Strong form efficiency 

The share prices of companies in strongly efficient markets incorporate everything that the semi-strong form efficiency incorporates but go a step further by also incorporating insider information. 

This implies that investors who know something about a company that isn't publicly known cannot generate abnormal returns trading off that information.

Generally speaking, you should expect more developed countries to have more efficient markets, mainly because more asset managers are analyzing stocks and more educated individuals make better investment decisions.

However, if any country were likely to display powerfully efficient markets, you would expect them to exist within more corrupt and opaque countries. This is because countries like the US and UK have implemented sanctions against insider trading purely because of how profitable it is. 

Investors with insider information are known to have an edge in markets, which is why there are policies in place dictating that asset managers and substantial shareholders must disclose their trades to the Securities and Exchange Commission ( SEC ). 

Under  Rule 10b-5 , the SEC explicitly states that insiders are prohibited from trading on material non-public information. 

In November 2021, a  McKinsey partner was charged with insider trading  because he assisted Goldman Sachs with its acquisition of GreenSky. 

The Mckinsey partner had private information regarding the GreenSky acquisition and purchased multiple call options on GreenSky, profiting over $450,000. 

Aside from the fact that the man was blatantly insider trading, the fact that he was able to profit off insider information is evidence that the US market does  NOT  possess strong form efficiency.

The above is somewhat considered to be proof by contradiction. If markets were efficient, trading off insider information would not let investors generate abnormal returns. But in this case, the Mckinsey partner could make almost half a million dollars!

To put that into perspective, $450 thousand is more than two years of the average investment banking analyst’s total compensation and slightly over four years of base pay. 

Are capital markets efficient?

After developing a decent understanding of the efficient market hypothesis, the real question is: is the market truly efficient, and do they follow the EMH? This topic is controversial, and many individuals will support different sides of the argument. 

Supporters of the efficient market hypothesis generally believe in traditional neoclassical finance. Neoclassical finance has been around since the twentieth century, and its approach revolves around key assumptions like perfect knowledge or rationality among individuals. 

In fact, most of the material taught at university and in textbooks are materials that talk about neoclassical finance - one might argue that the world of finance was built by theories such as the EMH. 

However, some of the assumptions in neoclassical finance have always been known to be overly restrictive and not at all realistic. For example, humans are not the objective supercomputers that neoclassical finance believes us to be. 

The fact is that humans are ruled by emotions and subjected to behavioral biases. We do not act the same as everyone else, and it is absurd to believe that we all behave rationally or even have perfect knowledge about a subject before making decisions.

Some of the latest developments in academics have been surrounding behavioral finance, with Nobel laureates including Robert Shiller and Richard Thaler (cameo in a classic finance film titled The Big Short) leading the field and relaxing unrealistic assumptions in neoclassical finance. 

Aside from being unable to generate alpha, another significant implication arising from the EMH is that investors can blindly purchase any stock in the exchange without any prior analysis and still receive a fair return on equity . 

That does not make sense because if everyone did that, then it would be safe to assume that the share prices would be wildly inaccurate and far apart from the company’s actual value. 

The fact is that there is some reliance upon financial institutions such as asset managers or arbitrageurs to constantly monitor and exploit inefficiencies within capital markets (such as buying underpriced and shorting overpriced equities) to keep the market efficient. 

Therefore, another argument arising from this is the idea that markets are efficiently inefficient where money managers who use costly financial information software such as Bloomberg Terminal or FactSet can gain a competitive edge in the market.

These money managers generate abnormal returns by exploiting inefficiencies within markets, such as longing for undervalued stocks or shorting overvalued stocks. A beneficial outcome of this activity is that market prices are slowly shifting towards efficient values.

The biggest argument supporting the efficient market hypothesis is that many money managers cannot outperform benchmark indices such as the S&P 500 on a year-to-year basis.

That argument is further supported when you compare the average 20-year annual return of the S&P 500 to any hedge fund’s average 20-year yearly return. You will find that  MOST  money managers underperform compared to the benchmark. 

The table below displays the November 2021 return of the top hedge funds. For reference, the S&P 500 had a total return of  26.89% . 

Therefore, if you compare the hedge funds to the S&P 500 (ignoring the hedge funds’ December 2021 performance), you can see that only three hedge funds outperformed the index. 

Hedge funds are also costly, with many institutions imposing a minimum 2-20 fee structure where there is a 2% fee charged on the AUM of the fund and a 20% fee for any profit above the hurdle rate. 

Nevertheless, while the data seems to point to the fact that hedge funds can be somewhat lackluster, a common argument is that the concept of a hedge fund is to “hedge,” which means to protect money. 

Therefore, perhaps some hedge funds have a greater purpose of maintaining their AUM rather than growing it despite the fact that hedge funds are known for having the most aggressive investment strategies . 

Overall, being a part of a hedge fund is still highly lucrative. For example, Kenneth Griffin, CEO of Citadel LLC, had total compensation of over $2 billion in 2021, whereas David Solomon, CEO of Goldman Sachs, had a total payment of $35 million in 2021. 

If you want to make $2 billion a year in a hedge fund one day, you need to polish up your interviewing skills. To impress your interviewers, look at Wall Street Oasis’s Hedge Fund Interview Prep Course . For a link to our courses, click  here .

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What is the Efficient Markets Hypothesis?

• Understanding the Efficient Markets Hypothesis
• Variations of the Efficient Markets Hypothesis

Arguments For and Against the EMH

Impact of the emh, related readings, efficient markets hypothesis.

"It is not possible to outperform the market by skill alone"

The Efficient Markets Hypothesis (EMH) is an investment theory primarily derived from concepts attributed to Eugene Fama’s research as detailed in his 1970 book, “Efficient Capital Markets: A Review of Theory and Empirical Work.” Fama put forth the basic idea that it is virtually impossible to consistently “beat the market” – to make investment returns that outperform the overall market average as reflected by major stock indexes such as the S&P 500 Index .

According to Fama’s theory, while an investor might get lucky and buy a stock that brings him huge short-term profits, over the long term he cannot realistically hope to achieve a return on investment that is substantially higher than the market average.

Understanding the Efficient Markets Hypothesis

Fama’s investment theory – which carries essentially the same implication for investors as the Random Walk Theory – is based on a number of assumptions about securities markets and how they function. The assumptions include the one idea critical to the validity of the efficient markets hypothesis: the belief that all information relevant to stock prices is freely and widely available, “universally shared” among all investors.

As there are always a large number of both buyers and sellers in the market, price movements always occur efficiently (i.e., in a timely, up-to-date manner). Thus, stocks are always trading at their current fair market value.

The major conclusion of the theory is 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. Neither expert stock analysis nor carefully implemented market timing strategies can hope to average doing any better than the performance of the overall market. If that’s true, then the only way investors can generate superior returns is by taking on much greater risk.

Variations of the Efficient Markets Hypothesis

There are three variations of the hypothesis – the weak , semi-strong , and strong forms – which represent three different assumed levels of market efficiency.

1. Weak Form

The weak form of the EMH assumes that the prices of securities reflect all available public market information but may not reflect new information that is not yet publicly available. It additionally assumes that past information regarding price, volume, and returns is independent of future prices.

The weak form EMH implies that technical trading strategies cannot provide consistent excess returns because past price performance can’t predict future price action that will be based on new information. The weak form, while it discounts technical analysis, leaves open the possibility that superior fundamental analysis may provide a means of outperforming the overall market average return on investment.

2. Semi-strong Form

The semi-strong form of the theory dismisses the usefulness of both technical and fundamental analysis. The semi-strong form of the EMH incorporates the weak form assumptions and expands on this by assuming that prices adjust quickly to any new public information that becomes available, therefore rendering fundamental analysis incapable of having any predictive power about future price movements. For example, when the monthly Non-farm Payroll Report in the U.S. is released each month, you can see prices rapidly adjusting as the market takes in the new information.

3. Strong Form

The strong form of the EMH holds that prices always reflect the entirety of both public and private information. This includes all publicly available information, both historical and new, or current, as well as insider information. Even information not publicly available to investors, such as private information known only to a company’s CEO, is assumed to be always already factored into the company’s current stock price.

So, according to the strong form of the EMH, not even insider knowledge can give investors a predictive edge that will enable them to consistently generate returns that outperform the overall market average.

Supporters and opponents of the efficient markets hypothesis can both make a case to support their views. Supporters of the EMH often argue their case based either on the basic logic of the theory or on a number of studies that have been done that seem to support it.

A long-term study by Morningstar found that, over a 10-year span of time, the only types of actively managed funds that were able to outperform index funds even half of the time were U.S. small growth funds and emerging markets funds. Other studies have revealed that less than one in four of even the best-performing active fund managers prove capable of outperforming index funds on a consistent basis.

Note that such data calls into question the whole investment advisory business model that has investment companies paying out huge amounts of money to top fund managers, based on the belief that those money managers will be able to generate returns well above the average overall market return.

Opponents of the efficient markets hypothesis advance the simple fact that there ARE traders and investors – people such as John Templeton, Peter Lynch, and Paul Tudor Jones – who DO consistently, year in and year out, generate returns on investment that dwarf the performance of the overall market. According to the EMH, that should be impossible other than by blind luck. However, blind luck can’t explain the same people beating the market by a wide margin, over and over again. over a long span of time.

In addition, those who argue that the EMH theory is not a valid one point out that there are indeed times when excessive optimism or pessimism in the markets drives prices to trade at excessively high or low prices, clearly showing that securities, in fact, do not always trade at their fair market value.

The significant rise in the popularity of index funds that track major market indexes – both mutual funds and ETFs – is due, at least in part, to widespread popular acceptance of the efficient markets hypothesis. Investors who subscribe to the EMH are more inclined to invest in passive index funds that are designed to mirror the market’s overall performance, and less inclined to be willing to pay high fees for expert fund management when they don’t expect even the best of fund managers to significantly outperform average market returns.

On the other hand, because research in support of the EMH has shown just how rare money managers can consistently outperform the market, the few individuals who have developed such a skill are ever more sought after and respected.

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Semi-Strong Form

Strong form, the bottom line.

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The Weak, Strong, and Semi-Strong Efficient Market Hypotheses

Learn about the three versions of the efficient market hypothesis

J.B. Maverick is an active trader, commodity futures broker, and stock market analyst 17+ years of experience, in addition to 10+ years of experience as a finance writer and book editor.

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.

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.

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.

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.

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 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 circumstance 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.

Titan, Alexandra. " The Efficient Market Hypothesis: Review of Specialized Literature and Empirical Research ." Procedia Economics and Finance , Volume 32, 2015, 442-449.

Aswath Damodaran. " Investment Valuation: Tools and Techniques for Determining the Value of Any Asset ." Page 120.

Burton Gordon Malkiel. "A Random Walk Down Wall Street: The Time-tested Strategy for Successful Investing," W.W Norton & Company, 2007.

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Efficient Market Hypothesis (EMH)

Step-by-Step Guide to Understanding the Efficient Market Hypothesis (EMH)

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What is the Efficient Market Hypothesis?

The Efficient Market Hypothesis (EMH) theory – introduced by economist Eugene Fama – states that the prevailing asset prices in the market fully reflect all available information.

Table of Contents

What is the Definition of Efficient Market Hypothesis?

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The efficient market hypothesis (EMH) theorizes about the relationship between the:

• Information Availability in the Market
• Current Market Trading Prices (i.e. Share Prices of Public Equities)

Under the efficient market hypothesis, following the release of new information/data to the public markets, the prices will adjust instantaneously to reflect the market-determined, “accurate” price.

EMH claims that all available information is already “priced in” – meaning that the assets are priced at their fair value . Therefore, if we assume EMH is true, the implication is that it is practically impossible to outperform the market consistently.

“The proposition is that prices reflect all available information, which in simple terms means since prices reflect all available information, there’s no way to beat the market.” – Eugene Fama

Weak Form, Semi-Strong, and Strong Form Market Efficiency

Eugene Fama classified market efficiency into three distinct forms:

• Weak Form EMH: All past information like historical trading prices and volume data is reflected in the market prices.
• Semi-Strong EMH: All publicly available information is reflected in the current market prices.
• Strong Form EMH: All public and private information, inclusive of insider information, is reflected in market prices.

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Broadly put, there are two approaches to investing:

• Active Management: Reliance on the personal judgment, analytical research, and financial models of investment professionals to manage a portfolio of securities (e.g. hedge funds).
• Passive Investing: “Hands-off,” buy-and-hold portfolio investment strategy with long-term holding periods, with minimal portfolio adjustments.

As EMH has grown in widespread acceptance, passive investing has become more common, especially for retail investors (i.e. non-institutions).

Index investing is perhaps the most common form of passive investing, whereby investors seek to replicate and hold a security that tracks market indices.

In recent times, some of the main beneficiaries of the shift from active management to passive investing have been index funds such as:

• Mutual Funds
• Exchange-Traded Funds (ETFs)

The widely held belief among passive investors is that it’s very difficult to beat the market, and attempting to do so would be futile.

Plus, passive investing is more convenient for the everyday investor to participate in the markets – with the added benefit of being able to avoid high fees charged by active managers.

Long story short, hedge fund professionals struggle to “beat the market” despite spending the entirety of their time researching these stocks with more data access than most retail investors.

With that said, it seems like the odds are stacked against retail investors, who invest with fewer resources, information (e.g. reports), and time.

One could make the argument that hedge funds are not actually intended to outperform the market (i.e. generate alpha ), but to generate stable, low returns regardless of market conditions – as implied by the term “hedge” in the name.

However, considering the long-term horizon of passive investing, the urgency of receiving high returns on behalf of limited partners (LPs) is not a relevant factor for passive investors.

Typically, passive investors invest in market indices tracking products with the understanding that the market could crash, but patience pays off over time (or the investor can also purchase more – i.e. a practice known as “dollar-cost averaging”, or DCA).

1. Random Walk Theory

The “ random walk theory ” arrives at the conclusion that attempting to predict and profit from share price movements is futile.

According to the random walk theory , share price movements are driven by random, unpredictable events – which nobody, regardless of their credentials, can accurately predict.

For the most part, the accuracy of predictions and past successes are more so due to chance as opposed to actual skill.

2. Efficient Market Hypothesis (EMH)

By contrast, EMH theorizes that asset prices, to some extent, accurately reflect all the information available in the market.

Under EMH, a company’s share price can neither be undervalued nor overvalued, as the shares are trading precisely where they should be given the “efficient” market structure (i.e. are priced at their fair value on exchanges).

In particular, if the EMH is strong-form efficient, there is essentially no point in active management, especially considering the mounting fees.

Since EMH contends that the current market prices reflect all information, attempts to outperform the market by finding mispriced securities or accurately timing the performance of a certain asset class come down to “luck” as opposed to skill.

One important distinction is that EMH refers specifically to long-term performance – therefore, if a fund achieves “above-market” returns – that does NOT invalidate the EMH theory.

In fact, most EMH proponents agree that outperforming the market is certainly plausible, but these occurrences are infrequent over the long term and not worth the short-term effort (and active management fees).

Thereby, EMH supports the notion that it is NOT feasible to consistently generate returns in excess of the market over the long term.

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