The Efficient Market Hypothesis (EMH) is a theory American economist Eugene Fama proposed in the 1970s. It asserts that in financial markets, asset prices always fully reflect all available information, making it impossible to outperform the market using this information consistently.
Key Tenets of the Hypothesis:
Prices Reflect All Information: At any given time, an asset’s market price incorporates all available information, both public and private. This means that current prices already include all known facts and expectations about future events.
Random Nature of Price Movements: Since prices instantly react to any new information, their movements are random. Therefore, it is impossible to predict future price movements based on past data or any other information.
Inability to Systematically Outperform the Market: Because all market participants have access to the same information and prices already reflect it, no investor can consistently earn returns above the market average without taking on additional risks.
Forms of Market Efficiency:
The Efficient Market Hypothesis is divided into three forms, each describing the extent to which information is available and reflected in asset prices:
Weak Form: This form asserts that current stock prices reflect all information about past prices and trading volumes. This means that analyzing historical data (e.g., technical analysis) cannot give traders an advantage, as this information is already factored into prices.
Semi-Strong Form: The semi-strong form suggests that asset prices reflect all publicly available information, including economic reports, news, financial statements of companies, and other publicly accessible data. This makes it impossible to earn excess returns based on fundamental analysis since all information is already incorporated into the current price.
Strong Form: This form claims that market prices reflect all information, both public and private (including insider information). Thus, even with exclusive or insider information, an investor cannot gain an advantage because the market has already fully accounted for it.
Criticism of the Hypothesis:
Although the Efficient Market Hypothesis dominated economic theory for a long time, it has faced criticism and re-evaluation. The main arguments against EMH include:
Market Anomalies: In reality, markets exhibit anomalies, such as the January effect, the small-cap effect, and others, which suggest that it is possible to earn excess returns using certain strategies.
Psychology and Behavioral Finance: Real markets may be inefficient due to human emotions and irrational behavior. Behavioral finance studies how cognitive and emotional factors can lead to deviations from rational pricing.
Insider Trading: The existence of insider trading cases indicates that private information can indeed provide an advantage in the market, contradicting the strong form of the hypothesis.
Financial Crises: Financial crises and market “bubbles” are examples of how prices can significantly deviate from the fundamental value of assets for extended periods, calling into question the idea of complete market efficiency.
