Efficient Market Hypothesis

Efficient Market Hypothesis is an investment theory that states that it is impossible to “beat the market” because existing share prices already incorporate and reflect all relevant information.

The EMH is a highly controversial and often disputed theory. Supporters believe it is pointless to search for undervalued stocks or try to predict trends in the market through any technique from fundamental to technical analysis, since an individual could achieve superior results from randomly picking stocks from a hat.

On the other hand, academics point to a large body of evidence in support of EMH. This includes the fact that since the balance of investors value stocks differently, it is impossible to ascertain what a stock “should” be worth in an efficient market. Also, investors such as Warren Buffett have consistently beaten the market.

The Efficient Market Hypothesis states that at any given time, security prices fully reflect all available information. The implications of the efficient market hypothesis are truly profound. Most individuals that buy and sell securities (stocks in particular), do so under the assumption that the securities they are buying are worth more than the price that they are paying, while securities that they are selling are worth less than the selling price. But if markets are efficient and current prices fully reflect all information, then buying and selling securities in an attempt to outperform the market will effectively be a game of chance rather than skill.

“An ‘efficient’ market is defined as a market where there are large numbers of rational, profit-maximizers actively competing, with each trying to predict future market values of individual securities, and where important current information is almost freely available to all participants. In an efficient market, competition among the many intelligent participants leads to a situation where, at any point in time, actual prices of individual securities already reflect the effects of information based both on events that have already occurred and on events which, as of now, the market expects to take place in the future. In other words, in an efficient market at any point in time the actual price of a security will be a good estimate of its intrinsic value.”

There are three forms of the efficient market hypothesis

  1. The “Weak” form asserts that all past market prices and data are fully reflected in securities prices. In other words, technical analysis is of no use.
  2. The “Semistrong” form asserts that all publicly available information is fully reflected in securities prices. In other words, fundamental analysis is of no use.

The “Strong” form asserts that all information is fully reflected in securities prices. In other words, even insider information is of no use

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