Efficient market hypothesis

Efficient market hypothesis
Source: Tavaga

Efficient market hypothesis or EMH is a theory which states that all securities are fairly priced, and the price reflects (or it anticipates) the present, past, and future information, both publicly and privately available in the market.

The theory requires information about factors affecting security to be quickly made available.

What are the forms of EMH?

  1. Weak Form:- it implies that the fundamental analysis doesn’t help any investor in any way. As the information that is gained from the analysis would already show in the price of the stock
  2. Semi-strong Form:- It implies that both fundamental and technical analysis won’t provide an edge to an investor
  3. Strong Form:- It implies that all the private information that is available is already shown in the price of the stock

EMH assumes that there is nothing like private information which can affect the price of the stock. Everything that is available is known to everyone and the stocks are already priced at fair value. Here efficient means Normal and every unusual event and unusual impact is normal and known to everyone. Therefore, the concept of active management doesn’t go well with the EMH.

How does the EMH theory work for investors?

Passive management of investments hinges on EMH and believes the markets are difficult to beat as information about a security is equally available to all, while active management believes in inefficient markets which belies information, and hence active human intervention can unlock alpha (i.e., achieve abnormal returns) based on previously unknown information for leverage.

During the current pandemic of COVID-19, there have been arguments over the vagueness of EMH theory because it has been proved that it is possible to outperform the market. There always exists market inefficiencies, and one can benefit from the private information available.