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The Efficient Market Hypothesis – Definition, Theory & What It Means For Your Investing

By Kalen Smith

business newspaper stocks glassesHow often have you read or heard news about a major company like Apple or Google and felt compelled to buy or sell the company’s stock? You want to invest in a company with a promising future, but once a story hits the news, is it already too late?

For years, financial experts have debated the efficient market hypothesis, which assumes that stock prices effectively reflect news and information.

You need to understand the hypothesis before investing – especially if you react to business news.

Laws of the Efficient Market Hypothesis

Most securities markets run smoothly and efficiently because so many investors are buying stocks and selling stocks regularly. The market has to form an equilibrium point based on those transactions, so the efficient market hypothesis says that it’s difficult to use information to profit. Essentially, the moment you hear a news item, it’s too late to take advantage of it in the market.

But not everyone agrees that the market behaves in such an efficient manner. In the ongoing debate, three different forms of the efficient market hypothesis emerge, and each one has a lot of evidence to support it.

  1. Weak form suggests that all previous market prices are already taken into account in the price of a stock. Investors can’t predict where a stock is moving by following previous price patterns through¬†technical analysis.
  2. Semistrong form means that all readily available information is already fully reflected by the stock price. Recent events and current financial statements are worthless in analyzing a security.
  3. Strong form claims that all information is fully reflected in the stock price. Even insider information is worthless when looking for opportunities.

Evidence Supporting these Debates

Professional studies analyze and verify how efficient these hypotheses really are. The debate will continue to rage, implying that markets are unlikely to be perfectly efficient or inefficient. As an individual investor you need to be aware of how efficiently markets process news and information.

The efficient market hypothesis isn’t absolute.¬†While conducting these studies, researchers uncovered a few anomalies that challenge the rule. The holes in the theory are opportunities that you can exploit as an investor.

  1. Stocks with low price-to-earnings ratios (P/E) or price-to-sales ratios (P/S) tend to outperform the market.
  2. Analysts frequently misprice foreign stocks.
  3. Because they tend to be riskier, smaller firms tend to outperform the market.
  4. Initial public offerings (IPOs) tend to underperform the market.
  5. Insider transactions often indicate that a security is going to move significantly up or down.
  6. Following past market data may help you predict future security prices in certain circumstances, like moving averages or trading range breaks.

Different markets tend to operate with different degrees of efficiency. Experts usually consider government bonds the most efficient market, and large CAP stocks come in a close second. Other assets such as real estate are less efficient because not everyone participates with the same understanding and access to information.

Responses & Critics to the Efficient Market Hypothesis

Even among investors who believe in the efficient market hypothesis, most pros accept that different asset classes are riskier investments than others and therefore can yield higher returns. When you’re investing, you’re trying to find your balance of risk and reward. The experts debating the issue may help you find your comfort level.

In 1973, Burton Malkiel wrote A Random Walk Down Wall Street and asserted his strong support of the efficient market hypothesis. He said that a blindfolded chimpanzee could throw darts at the Wall Street Journal and choose investments that did just as well as the ones seasoned experts choose. He suggested investing in broad-based index funds that held all the stocks in the market and charged low interest rates.

Richard Spurgin, my business school professor, was a well-respected member of the financial community. He believed in the efficient market hypothesis, but he also addressed some market anomalies. He worked as a technical analyst – trying to predict future price movements of securities based on historical prices – right after he got his degree. Even as an advocate of efficient markets, he felt that there was an opportunity to profit from these strategies in certain situations.

Personally, I left business school feeling that the opportunity to make monumental returns from investing in the stock market wasn’t as great as I originally thought. I gave up my dream of becoming the next Warren Buffett. Despite the fact that the topic has been so strongly debated on both sides, I feel that the efficient market hypothesis has so much evidence to support it that the only way you can outperform the market is by taking greater risks.

Some investment portfolios may outperform the market in a given year, which of course doesn’t disprove the efficient market theory. Portfolios need to beat the market consistently to be considered extraordinary. So few investors have managed to have consistent success that I’m convinced the efficient market hypothesis is at least partly true. Portfolios that achieve 30% returns in a given year are amazing, but these same – risky – portfolios are likely to lose their gains the following year.

Final Word

I follow Malkiel’s suggestions. If you take moderate amounts of risk and diversify your assets and stock investment portfolio, you’re much better off than you’d be placing all of your eggs in one basket. I don’t want to discourage you from analyzing a security, but don’t be cocky about your investing skills. If most full-time money managers can’t come close to beating the market, you probably don’t have a great chance either.

Decide for yourself how you feel about the efficient market hypothesis. Maybe you think you can beat the market. Just make sure you still look at the evidence and diversify. The last thing you want to do is invest all of your money in one security only to lose it. Remember, just one news story doesn’t give you the whole picture. Perform extensive research by utilizing some of the best stock market investment news and analysis sites. Securities markets are complicated, and you need to study plenty of variables to understand where a particular security is headed.

(photo credit: Shutterstock)

Kalen Smith
Kalen Smith has written for a variety of financial and business sites. He is a weekly contributor for Young Entrepreneur and has worked as a guest blogger on behalf of Consumer Media Network. He holds an MBA in finance from Clark University in Worcester, MA.

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  • Kurtis Hemmerling

    Great article explaining what the efficient market is. I find the EMH theory a bit depressing since it goes hand in hand with the Random Walk theory that suggests making money in the market is quite difficult. There are no bargain stocks since they are all priced according to risk, so if you hold any large basket of stocks you should only get the market average. Larger risk could mean larger reward, but this too should average out between big winners and large losers. I prefer to think that the market is mildly efficient, and that careful analysis can reveal stocks outperforming the market but without the same downside risks. Just a feeling though.

  • Kalen Smith

    Thank you Kurtis I personally agree but maybe its the optimist in me. Nevertheless, we need to be realistic about how hard it really is o beat the market. We may want to believe that our extraordinary gains were due to our knack for picking the right stocks, but it could also be that we just got lucky. Of course, we may not get lucky every year. But you’re right, the efficient market hypothesis is just that, a hypothesis. We don’t know for sure how accurate it is and have to just use our own judgment.

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