How efficient market hypothesis helps make better investment decisions

Summary:

In the world of finance, the efficient market hypothesis (EMH) says that financial markets are very efficient and that it is not possible to consistently earn higher returns than the market average since the prices of assets already reflect all the information that is available. This blog explains in detail how that may or may not always be true.

Introduction to efficient market hypothesis

In the world of finance, the efficient market hypothesis (EMH) theorises that money and financial markets are very efficient and that it is not possible to consistently earn higher returns than the market average since the prices of assets already reflect all the information that is available. Its implication is that it is impossible to outdo the market by means of market timing and/or stock picking because any factor that could affect the price of a stock is already affecting the current market price.

Forms of EMH:

The efficient market hypothesis has three major forms:

• Weak form EMH: In this form, there is the assertion that all trading information of the past, which includes price and volume data, is already reflected in the prices of the stock. As a result, technical analysis, which includes studying volume patterns and past prices, cannot be put to use to make consistent predictions about price movements in the future.
• Semi-strong form EMH: This form, which is an extension of the weak form, posits that all information that is publicly available, such as financial statements, news, and other types of public data, are already incorporated into the prices of stocks. For this form of EMH, neither technical analysis nor fundamental analysis (analysing economic and financial data) can be implemented to outperform the market consistently.
• Strong form EMH: This is an assertive form of the hypothesis. It suggests that all information, irrespective of whether it is private or public, is fully reflected in the prices of the stock. Because of this, not even insiders, who would have access to confidential information, can earn unreasonably high returns by trading using that information.

Reasoning behind EMH:

In the world of finance, there has always been extensive debate about efficient market hypothesis over the years. Critics EMH have argued that markets are not always perfectly efficient. This would mean that there are possibilities and instances when investors can find overvalued or undervalued assets that achieve returns that are above average. These critics suggest that bubbles and anomalies in financial markets are what debunk the concept of the strong form of EMH.

Despite the ongoing debate, EMH continues to be an important and critical theory in the world of finance. It has had a massive impact on the formulation of investment strategies, as well as understanding market behavior. Investment professionals and analysts continue to use its principles for their work while accepting that market forces may not always operate in perfectly efficient ways.

Advantages of EMH

The concept of EMH has many benefits and advantages. These include:

• Incorporation of information: EMH states that data from financial markets is swiftly and efficiently incorporated into asset prices,. This is an advantage because it means that investors can trust market prices to be accurate reflections of the actual value of assets. Because the market prices are true and accurate, they will not need to invest resources and time to conduct research and analysis.
• Reduction of risk: EMH can be handy for investors to manage risk. If the markets are actually efficient, it would be difficult for an investor to continuously outperform the market by tracking down mispriced securities. This would imply that investors are not likely to make errors in assessment, which reduces the chances of investment decisions that backfire.
• Cost savings: Investors are able to save resources and time by not having to conduct extensive analysis and research in their efforts to 'beat the market.' In fact, they can choose passive investment methods such as exchange-traded funds or index funds which try to replicate the performance of the market. These usually entail lower fees in comparison to actively managed funds.
• Market integrity: The concept of EMH suggests that the markets are transparent and fair. This enhances the integrity of the market and boosts investors' confidence because it implies that all participants operate at level playing field and that the chances of market manipulation are minimal.
• Focus on long-term investments: Through EMH, investors are encouraged to adopt strategies that are meant for the long term instead of resorting to speculation in the short term. This can be handy for investors who are keen on building wealth steadily over time.

Summing up

Despite the optimism surrounding EMH, it does have its share of limitations and criticisms. Critics are of the opinion that markets are not fully efficient and that bubbles, anomalies, and biases in behaviour can result in inefficiencies. It is thus advised that investors rely on a combination of active and passive investment outlooks which take into account both the limitations and advantages of EMH.