What is Efficient Market Hypothesis?

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Investors look for any advantage in order to turn a profit in the stock market. And that includes doing research and developing theories in order to explain market movements and behavioral patterns. Perhaps the most well-known is EMH or Efficient Market Hypothesis.

Like many market theories, EMH attempts to explain how stocks are priced and how investors can take advantage. Some ideas suggest that markets are fairly priced and offer no advantage to investors, while others indicate just the opposite. Investors that want to understand markets better need to know what EMH means and how it applies to investing.

Breaking Down Efficient Market Hypothesis

There are three forms of EMH: strong form, semi-strong form, and weak form. Each type makes different assumptions about the market and investors in an attempt to explain pricing inefficiencies. In essence, EMH theorizes that markets as a whole are efficient and investors cannot make a profit from undervalued stocks and can only profit from taking on higher risks.

Strong Form EMH

The strong form hypothesis states that all possible information, public and private, is always reflected in a stock’s price. This means that investors can’t have insider knowledge that allows them to profit, since the price always reflects a fair value.

Semi-Strong Form EMH

In the semi-strong form of EMH, technical analysis is assumed useless, but fundamental analysis is still valid. The stock’s price reflects all publicly available knowledge, so insiders would be able to profit from information that others do not yet possess. It also assumes that any new information is automatically processed, understood by all at the same time and reflected in the stock price.

Weak Form EMH

Finally, weak form EMH states that stock prices reflect all historical data, meaning that past knowledge and information cannot be used to predict future price movements. In other words, this form assumes that future price movements are more or less random and can’t be predicted by analysts who use past data to make assumptions about the future.

Flaws in the System

While EMH may help explain certain unexpected price movements and patterns in the markets, it has several glaring holes in its logic. The biggest problem with EMH is that it assumes all investors are unbiased in their analysis, make no flaws and act rationally in response to information. However, as the newly formed field of behavioral finance shows, investors do not always act rationally or make decisions based on logic. Furthermore, a single piece of data isn’t always viewed the same. Many times, new information sparks conflicting views, leading to pricing inefficiencies.

Behavioral finance is quickly replacing EMH in terms of being the premier trading philosophy used by major institutional investment companies. For everyday investors, this means undervalued stocks exist on a daily basis and using fundamental analysis can reveal pricing inefficiencies that investors can take advantage of. Regardless of what others might say, the markets operate based on human behavior. And human behavior is often irrational and impossible to predict.