What Is Efficient Market Hypothesis?

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The ability to predict the stock market is an art. Those who are good at it can make money, while those who are bad at it should trust the experts. However, there’s one theory that states that predicting the market is impossible since the price you see reflects the latest information on a particular asset. This theory is the efficient market hypothesis, and it’s often disputed.

TL;DR (Too Long; Didn't Read)

An efficient market hypothesis is a theory that states that the price of a stock reflects its fair market value at the time.

Efficient Market Hypothesis

Some date the efficient market hypothesis all the way back to the year 1900, when French mathematician Louis Bachelier first proposed it in his dissertation, "The Theory of Speculation." However, that was far from the only time the theory was proposed. It has been mentioned in connection with a 1565 hypothesis relating to gambling. However, the theory became more popular in the 1960s, when technology made it easier to track the latest prices of every stock on the market.

The efficient market hypothesis states that no matter how long we compare the values of various assets or look for undervalued stocks, the process is pointless. The price we see reflects what is currently known about each stock, the hypothesis states. But one thing possibly debunking this theory is that there are plenty of people who have beaten the market simply by studying them, including Warren Buffet.

What the Efficient Market Hypothesis Means

There’s a reason the validity of the market hypothesis is so hotly debated. Those who believe in it advise that investors are better off filling their portfolio with low-cost stocks. The price a stock fetches now is the price it is worth, the argument goes, and that information is the most anyone has at that time.

Due to EMH, some experts believe that it’s a waste of time to try to beat the market since it can’t be done. Depending on how thoroughly they believe in EMH, proponents think the price of a stock at least reflects its past performance. But some believe that it reflects everything from past performance to the top-secret information only executives behind the stock know.

The Issues With Efficient Market Hypothesis

A basic economic principle states that the fair market value of something is what someone is willing to pay for it. If that’s the case, a good argument against EMH is that if one investor sees the value of something as what it’s worth and the other bases its value on its growth potential, that asset already has two completely different fair market values. Therefore, one of the biggest arguments is that a stock’s current value will always be subjective.

Another argument against EMH is seen in the concrete proof that different investors get different results. If every investor chose the most affordable stocks they could find, that would mean every investor would get the same results. The truth is, a stock’s price can change unexpectedly from one day to the next, based on factors outside of an investor’s control. The fact that a percentage of investors build a highly successful portfolio and some have no luck whatsoever shows that EMH may not be the hypothesis to follow.

Predicting Future Values

Even though the efficient market hypothesis states that a stock is worth its asking price, investors have made an art out of predicting how well a stock will do in the future. For example, if you had put $11,000 into Amazon in 1997, it would have been worth almost $4.3 million by 2016. A $990 investment in Apple in 1980 would be worth $521,740.80 today.

Unfortunately, unless you have a crystal ball, there would be no way to predict a stock’s future. By the time a stock starts to show tremendous promise, other investors are already on it, driving its price up substantially. Netflix is an example of a company that has had its ups and downs over the years. It started as a DVD mail rental business, then branched off into a streaming service. Over the years, investors have seen the company take numerous dips in the market, most recently when the company announced that subscriber growth had slowed. Since the market reacts to any news, even when an investor thinks he’s put money into a stock that can’t lose, one marketing slipup or customer dip can create problems.

Technology and the Efficient Market Hypothesis

Interestingly, technology has led to EMH becoming more valid in recent years. Thanks to software, investors can now get immediate updates on how stocks are performing. Since investor behavior drives market performance, that means that one small fluctuation can cause a large group of investors to sell, dropping the value of a stock immediately.

Another way technology is contributing to EMH is that software can now automate the process of buying and selling stocks. This is done using a strict mathematical formula with little room for human reason. However, in many cases, humans still often make decisions based on their intuition. So as long as the process isn’t 100-percent automated, EMH won’t be a certainty.

What Are the Functions of the Secondary Market?

Complicating matters slightly is the secondary market, which is where investors buy and sell stocks they already own. When they initially buy a stock, this is known as the primary market, which is also where initial public offerings happen. In an IPO, all proceeds go directly to the business issuing it, with investors then waiting to see how their investment will perform.

However, when those same investors decide to sell those stocks, this is done on the secondary market. The proceeds of those sales go to the investor who holds the stocks, rather than the initial company. On the primary market, the value of the stock is set by the company, but it is based on comps from similar stocks already on the market. On the secondary market, though, the price of a stock is driven by supply and demand. The more investors see promise in a stock, the more interest there will be, driving prices up.

EMH and a Financial Crisis

In an efficient market hypothesis paper, a market strategist linked the 2007 financial crisis to the EMH. Due to a belief in the hypothesis, Jeremy Grantham has stated that experts chronically underestimated the danger that an asset bubble might eventually burst. Soon after, other experts chimed in, even going so far as saying that EMH led investors and analysts to follow what the market was saying, rather than looking deeper into each asset’s true value.

Perhaps most importantly, however, was that an asset bubble was allowed to happen in the first place. The paper looked at historical events like Dutch tulip mania in 1637, as well as other historical financial crises that occurred long before EMH was widespread knowledge. However, it’s important to note that since many don’t follow EMH in their investment practices and instead use their judgment and intuition when building their portfolios, many experts believe EMH’s role in the 2007 financial crisis was limited.

Weak Versus Semi-Strong Versus Strong

There are three types of efficient markets: weak, semi-strong and strong. An efficient market hypothesis weak form says that an investor doesn’t have access to all available information on an asset and therefore must rely on historical data. When this is the case, opponents argue, investors are at a disadvantage because historical information does not necessarily predict an asset’s future performance.

Semi-strong EMH suggests that in addition to historical data, publicly available information is always factored into the price of a stock and therefore that price is generally up-to-date. Then there’s the strong EMH, which states that even private insider knowledge is usually reflected in a stock’s price and therefore no guesswork remains.

What Is an Inefficient Market?

As many efficient market hypothesis forms as there are, there are also plenty of inefficient market forms. A sound investment strategy may involve a combination of both. An inefficient market describes one where the market prices of an asset aren’t indicative of its actual value. This means that among all of the stocks on the market, bargains are available, which means an investor can turn a purchase into a big win if she plays the market correctly.

Thoughts don’t fall only on one side or another, though. Some people believe that an efficient market approach works with some stocks and an inefficient method works with others. Since large-cap stocks are so closely followed, investors may be wise to assume that the listed price is the real value of that stock and choose the best value. Small-cap stocks, on the other hand, tend to be a bit more mysterious, since their every activity isn’t blasted across CNBC every morning. These lesser-followed stocks may be ideal for getting a great deal on an asset that will unexpectedly skyrocket in value.

Investing in an Efficient Market

If the efficient market hypothesis holds true, picking stocks is a waste of time. EMH believers think that index funds and exchange-traded funds are the best routes to go since they aren’t aiming to beat the market. Instead, they simply put your money where stocks are performing best on a given day, which should give you the best bang for your buck if EMH is true.

But the problem with such funds is that they do not protect you if the entire market takes a nosedive. There also could be a sector-wide issue that affects multiple stocks in the same sector, all of which are part of the same value-weighted index. Exchange-traded funds can also be problematic due to their high fees – a problem if your goal is to get a great deal. You also lack an element of control when you turn your money over to these types of funds, which can not only be frustrating, but it may take some of the fun out of playing the market.

Debunking the Efficient Market Hypothesis

Although there is evidence that much of the market is efficient, there’s proof of an inefficient market, as well. One example of this is the recent crypto crash, in which cryptocurrency investors lost big. For months, investors rushed to put money into technologies like bitcoin, following the news that digital forms of currency were the next big thing. Experts attributed the crash to an overhyped investment vehicle, driven by too many investors buying into what they were hearing. Unfortunately, security issues and government regulations weighed everything down, gradually harming the entire market.

The cryptocurrency crash has been compared to the dotcom bubble of the 90s, which followed a few years of excited investing in technology stocks. As the newness wore off, the market couldn’t hold up, leading to enormous losses. The EMH counters this by stating that economic bubbles don’t exist in the first place, seeing it as rapid changes in expectations about a particular asset. Since these changes can’t be predicted, EMH proponents would say that the prices reflected what the stocks were worth pre-crash, then they lowered to what they were now worth post-crash. However, many experts say bubbles can be predicted and have been able to pinpoint certain economic behaviors that lead to such market downturns.

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About the Author

Stephanie Faris is a novelist and business writer whose work has appeared on numerous small business blogs, including Zappos, GoDaddy, 99Designs, and the Intuit Small Business Blog. She worked for the State of Tennessee for 19 years, the latter six of which were spent as a supervisor. She has written about business for entrepreneurs and marketing firms since 2011.