According to the EMH, stocks always trade at their fair value on exchanges, which prevents investors from buying undervalued stocks or selling stocks at too high a price. Therefore, it is impossible for investors to beat the overall market through expert stock picking or market timing, and the only way to achieve higher returns is to purchase riskier investments.

Key Points

• The Efficient Market Hypothesis (EMH) or theory holds that stock prices reflect all information.
• EMH assumes that shares trade on exchanges at their fair market value.
• Proponents of EMH believe that investors should benefit from low-cost passive investment portfolios.
• Opponents of EMH believe that it is possible to beat the market and that stocks may deviate from their fair market value.

Understand the efficient market hypothesis (EMH)

Although EMH is a cornerstone of modern financial theory, it is highly controversial and often questioned. Believers believe that trying to find undervalued stocks or predict market trends through fundamental or technical analysis is a fool's errand.

In theory, neither technical analysis nor fundamental analysis can consistently generate risk-adjusted excess returns (alpha), while only inside information can achieve exceptional risk-adjusted returns.

$599,090.00: On February 9, 2024, the share price of the world’s most expensive stock, Berkshire Hathaway Class A shares (BRK.A).

Although academics point out that there is a large amount of evidence supporting EMH, there is also considerable dissent. For example, investors such as Warren Buffett consistently beat the market over the long term, which is impossible under the EMH definition.

Opponents of EMH also point to events such as the 1987 stock market crash, when the Dow Jones Industrial Average plummeted more than 20% in one day, and asset bubbles as evidence that stock prices can deviate significantly from their fair value.

IMPORTANT NOTE: The assumption of market efficiency is a cornerstone of modern financial economics, but has been questioned in practice.

Special Considerations

Proponents of the efficient markets hypothesis argue that due to the random nature of markets, investors may earn better returns by investing in low-cost, passive portfolios.

Data compiled by Morningstar in its June 2019 Active/Passive Benchmark Study supports EMH. Morningstar compared active manager returns in each category to the combined returns of underlying index funds and exchange-traded funds (ETFs). The research found that in the 10 years starting in June 2009, only 23% of active managers were able to outperform their passive peers. Foreign stock and bond funds have higher success rates, while U.S. large-cap funds have lower success rates. Overall, investors perform better by investing in low-cost index funds or ETFs.

While a subset of active managers outperform passive funds at certain points in time, the challenge for investors is identifying which managers can sustain this performance over the long term. More than 25% of high-performing active managers are unable to consistently outperform their passive peers over time.

What does market efficiency mean?

Market efficiency refers to the extent to which prices reflect all available information. The efficient market hypothesis (EMH) believes that the market is efficient, so there is almost no room for excess profits through investment, because all prices are fairly and accurately reflected. This means that there is little hope of beating the market, although market returns can be matched through passive index investing.

Is the efficient market hypothesis valid?

The effectiveness of EMH has been questioned at both theoretical and empirical levels. Some investors, like Warren Buffett, have beaten the market by focusing on undervalued stocks, reaping billions of dollars in returns and setting an example for legions of followers. There are also portfolio managers who outperform others, and some investment firms that are more reputable in their research analysis. However, proponents of EMH argue that those who outperform the market do so not because of skill but because of luck, due to the law of probability: In a market with many participants, there will always be some who perform better than the average and others who perform worse.

Is it possible for markets to be inefficient?

It is true that some markets are less efficient than others. In an inefficient market, asset prices do not accurately reflect their true value, which can occur for a variety of reasons. Market inefficiencies can exist due to factors such as information asymmetry, insufficient buyers and sellers (i.e. low liquidity), high transaction costs or delays, market psychology and human emotions. Inefficiency often results in a waste of resources. In reality, most markets do exhibit some degree of inefficiency, and in extreme cases, inefficient markets may manifest themselves as market failures.

It can be difficult to accept the pure (strong) form of EMH, which assumes that all information in the market, whether public or private, is already factored into the stock price. However, EMH also exists in modified forms to reflect its suitability in the market:

• Semi-strong validity: This form of EMH considers that all public (but not non-public) information has been factored into the stock's current share price. Neither fundamental nor technical analysis can yield excess returns.
• Weak validity: This EMH states that all historical prices of the stock are reflected in today's stock price. Therefore, technical analysis cannot be used to predict and outperform the market.

How to improve market efficiency?

The more market participants there are, the more efficient the market is because more people compete and introduce more and different types of information on prices. As markets become more active and liquid, arbitrageurs will emerge to profit from correcting small inefficiencies and quickly restore market efficiency.

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