Efficient Market Hypothesis (EMH) Definition
The Efficient Market Hypothesis (EMH) is a crucial theory in financial economics suggesting that the prices of assets in financial markets reflect all relevant and available information at any given point in time. Therefore, it becomes almost impossible for investors to beat the market on a consistent basis since market prices should only react to new information.
Efficient Market Hypothesis (EMH) Key Points
- Prices in an efficient market should reflect all available information, presenting a fair value of the asset.
- The theory suggests it’s practically impossible to consistently outperform the market.
- EMH is often a foundational concept in discussions about market manipulation, insider trading, and stock pricing.
What is the Efficient Market Hypothesis (EMH)?
The efficient market hypothesis is a financial concept formulated by Professor Eugene Fama in the 1960s. It theorizes that stock markets are ‘efficient’, and the prices of the stocks at any given time accurately reflect all available and relevant information. The idea presented manifests that it would be impossible for an investor to outperform the market, or ‘beat’ it, over any significant time frame since no one can have access to any undisclosed information.
Why is the Efficient Market Hypothesis (EMH) Important?
The importance of the EMH is reflected in three different degrees: weak, semi-strong, and strong forms. Each of these forms postulates a different degree of efficient market, where the weak form suggests that historical prices cannot predict future prices, the semi-strong form postulates that all public information is reflected in stock prices, and the strong form suggests that all public and private information is already priced into stocks. Understanding these principles helps to determine pricing strategies, inform investment decisions, and provoke thoughts on market regulation.
Who Uses the Efficient Market Hypothesis (EMH)?
The EMH is primarily used by investors and financial economists to guide their investment strategies. It is also used as a theoretical benchmark by financial researchers. Regulatory bodies too, may consider the implications of the EMH when discussing issues related to market manipulation, trading practices, and investor protection measures.
When is the Efficient Market Hypothesis (EMH) Used?
EMH is often applied when making financial investment decisions, when researchers are crafting new financial theories, or when regulatory bodies are considering new policies related to stock market practices.
How does the Efficient Market Hypothesis (EMH) Work?
The EMH posits that there are enough participants in a market such that any single participant cannot profit above the average on a consistent basis, barring trading randomly or by receiving and acting upon new information before it is dispersed to the broad market. The hypothesis suggests that in order for someone to outperform the market, they must discover and react to new information before the rest of the participants in order to gain an advantage. This idea comes from the belief that the market price reflects the fair value of an asset, and that any undervaluation or overvaluation is quickly corrected once new information becomes available.
