Everything you need to know about Efficient Market Hypothesis

Everything you need to know about Efficient Market Hypothesis

- in Finance
153
0

Efficient Market Hypothesis (EMH) was introduced in the 1960s by Eugene Fama, an American economist who is widely known as the father of modern finance. According to this investment theory, the prices of all financial instruments factor in their inherent properties, and this information is available to all participants equally and without bias. This theory aims to answer the question – is the stock market efficient?

Simplifying Efficient Market Hypothesis (EMH)

EMH is based on some core assumptions that lend validity and credibility to it. These are:

  • All the stocks in the market trade at a fair value, and the information is publicly available for everyone to access and use. So, if you are trading on a particular stock, you would safely assume that the stock’s market value is based on the available relevant information that even your friend/colleague may have access to.
  • There’s no external influence or unfair practice to alter the prices of the stock. All transactions and market behaviour follow an ethical code, and you too would abide by the same.
  • You may not be able to outperform the market because your decisions are based on the same information available to everyone trading along with you.

Once the assumptions are established, you can then look at the different types of EMH.

Types of Efficient Market Hypothesis

1.Weak form EMH

The assumption states that all historical data, including the price and returns, are reflected in the stock’s prices. Thus, no form of technical analysis can be used to outperform the stock market. Using fundamental analysis, however, investors can identify undervalued and overvalued stocks and earn extraordinary returns.

2.Semi-strong form EMH

This form supplements the assumptions in the weak form and emphasises the dynamic nature of stock prices. It elaborates that the stocks to buy today will have quick adjustments in prices in response to all publicly available information. Thus, neither technical analysis nor fundamental analysis can help you gain a competitive advantage.

3.Strong form EMH

This form states that all historical and current information, both public and private, is factored into the market prices of the securities. This removes the possibility of any undue advantage to anyone and reiterates the belief that the market is perfect. Beating the market in such a condition is next to impossible for anyone.

Impact of EMH

While it is relatively easy to dismiss the idealistic claims of EMH, it has still been around for quite some time now. It is steadily growing in relevance even today. Stock market participants who believe in this hypothesis often put it to use while investing in mutual funds that replicate its parameters.

EMH and investments – How to go about it?

Efficient Market Hypothesis is ideal for investors looking for a long-term investment strategy rather than something for short term. You as an investor will thus have to plan your investments by running risk profiles and setting goals based on information available to know if the stock market is efficient for you.

Leave a Reply

Your email address will not be published. Required fields are marked *