Understanding the efficient market hypothesis: definition and strategies

The efficient market hypothesis is a concept in financial economics that provides an explanation of how markets work. The hypothesis is based on specific assumptions about the market and investors. If you are involved in financial investments, the ideas introduced by this hypothesis can guide you in making sound investments that provide returns that match the market. In this article, we define the EMH, examine its forms, look at some EMH investment strategies, and discuss some of the critics of the efficient market hypothesis.

What is the efficient market hypothesis (EMH)?

The Efficient Market Hypothesis, or EMH, is an investment hypothesis that asserts that the stock market is an efficient marketplace where stock prices always accurately reflect fair value, and investors cannot earn higher than standard returns without taking on higher than standard risks. The EMH is based on two assumptions: – Investors behave rationally. They strive to use their knowledge and skills to earn the greatest profits; – All available information has already been included in a stock’s price, and this can only change if new information, such as earnings reports or news articles, becomes available in the future. But because no one can predict the content or nature of that information, they can’t predict the stock’s price movement either. If EMH is true, then the following is true: – Existing stock prices are accurate estimates of investment value. – It is impossible for investors to consistently predict future price movements; – It is impossible for investors to consistently beat the market or see better risk-adjusted returns on investment than the industry standard. Therefore, no amount of research or analysis can give you an advantage over others, as everyone has access to the same information. Thus, if there is currently a stock available for $50 per share, the EMH says the valuation already has all the available information about supply and demand, the company’s profitability, and other forces that may affect the stock’s price. There is no way to identify a more accurate value because all the data you could conceivably examine has already been taken into account. Forms of EMH There are three forms or levels of EMH, each with its own statement about the market:

Weak form

Weak form EMH indicates that current stock prices reflect all market data available at the time and that historical price movements have no bearing on future price movements. Therefore, technical analysis, or evaluating investments based on historical data, cannot help an investor spot patterns or predict future price movements, historical data has already included the price. What can provide a benefit to investors is fundamental analysis, or an analysis of all the factors that contribute to a stock’s value, but this is not a long-term benefit.

Semi-rigid form

Semi-strong EMH argues that stock prices have incorporated all information that is publicly available. Therefore, even fundamental analysis cannot give investors an advantage, as the information they could possibly reveal has already been taken in and adjusted the share price.

Strong form

Strong-form EMH states that all available information, both publicly known and privately known, factors into a stock’s price. Therefore, no one can consistently beat the market. Strong-form EMH admits that higher-than-standard returns are possible, but you can’t continuously get abnormally high returns on investments over the long term.

EMH investment strategies

If the EMH is true and investors cannot gain an advantage in the market because stock prices already reflect all useful information, then the best investment strategy would be a passive one, where there is minimal buying and selling and investors buy securities to hold them over the long term. The goal of passive investing is gradual accumulation of wealth rather than quick profit from short-term price volatility. Passive portfolio managers are likely to believe, as the EMH claims, that it is impossible to beat the market over the long term, so the best strategy is to match market returns. Investors who follow the EMH often invest in index funds. Index funds are a type of mutual fund, a financial vehicle that combines money from different investors to invest it in stocks, bonds and other securities. An index fund passively tracks a stock market index, such as the Dow Jones Industrial Average and the S&P 500 Index. Index funds are a sound EMH investment strategy because they only aim to match the market, not beat it, in line with EMH’s founding principle.

Criticism of the EMH

There have been several critics of the EMH throughout its history. Much of the criticism comes from fundamental analysts, who take into account factors such as historical data when assessing a company’s current health and predicting its future performance. Fundamental analysts may argue that historical data can be useful. For example, if a company that has historically enjoyed strong profits and growth, it is reasonable to believe that it can continue to earn and grow well. Fundamental analysts and value investors, who pick stocks that appear to be trading for less than their true value, also directly refute the EMH’s basic premises. For example, they say that:

Investors can be irrational

Individual investors may follow trends and neglect to perform the necessary research on their investment choices. In addition, they may exhibit abnormal behavior, such as selling when they should be buying, or vice versa, in a gamble to gain an advantage. Speculative bubbles – situations where the price of something like a stock or asset far exceeds its value – are examples of irrational investor behavior. If the EMH were true, the market would not allow bubbles to form.

Share price does not reflect all available information

The information may be available, but it may not have been taken into account in the share price. Often a stock is undervalued due to circumstances unrelated to fundamental analysis and other factors that affect stock prices. For example, large investment firms may overlook a high-growth stock in favor of those that are trending, and this lack of demand can push down the price. If an investor finds one of these overlooked stocks, they will see higher than standard capital gains on it, defying the EMH.

About the Vikingen

With Vikingen’s signals, you have a good chance of finding the winners and selling in time. There are many securities. With Vikingen’s autopilots or tables, you can sort out the most interesting ETFs, stocks, options, warrants, funds, and so on. Vikingen is one of Sweden’s oldest equity research programs.

Click here to see what Vikingen offers: Detailed comparison – Stock market program for those who want to get even richer (vikingen.se)