Efficient Market Hypothesis (EMH)
The Efficient Market Hypothesis, developed by Eugene Fama in 1970, is one of the most debated theories in finance. It argues that asset prices fully reflect all available information, making it impossible to consistently "beat the market."
Core Concept
In an efficient market:
- Prices adjust rapidly and accurately to new information
- Securities are fairly priced at all times
- No investor can consistently earn risk-adjusted excess returns
- Active management cannot systematically outperform passive strategies
The Three Forms of EMH
Each form makes progressively stronger claims about what information is reflected in prices:
Weak Form Efficiency
Claim: Prices reflect all historical market data (past prices, volume, trading patterns).
| What's Reflected | Analysis That Won't Work | Analysis That Might Work |
|---|---|---|
| Past prices | Technical analysis | Fundamental analysis |
| Historical volume | Chart patterns | Insider information |
| Previous returns | Momentum strategies | — |
Implication: Technical analysis is useless. You cannot predict future prices by studying past prices.
Semi-Strong Form Efficiency
Claim: Prices reflect all publicly available information (financial statements, news, economic data).
| What's Reflected | Analysis That Won't Work | Analysis That Might Work |
|---|---|---|
| All public information | Technical analysis | Insider information |
| Financial statements | Fundamental analysis | — |
| Economic data | News-based trading | — |
| Analyst reports | — | — |
Implication: Neither technical NOR fundamental analysis can produce excess returns. By the time you read a financial statement or news article, the price has already adjusted.
Strong Form Efficiency
Claim: Prices reflect ALL information, including private (insider) information.
| What's Reflected | Analysis That Won't Work |
|---|---|
| All public information | Technical analysis |
| All private information | Fundamental analysis |
| Insider knowledge | Insider trading |
Implication: Even insiders cannot profit from their information. This form is generally NOT supported by evidence—insider trading prosecutions prove that private information has value.
Summary of EMH Forms
| Form | Information Reflected | Technical Analysis | Fundamental Analysis | Insider Trading |
|---|---|---|---|---|
| Weak | Past prices/volume | Useless | May work | May work |
| Semi-Strong | All public info | Useless | Useless | May work |
| Strong | All info (public + private) | Useless | Useless | Useless |
Evidence For and Against EMH
Evidence Supporting EMH
Active Manager Performance:
- Over 15 years, 88% of large-cap active managers underperform the S&P 500
- Only about 29% of active funds beat their benchmark over a decade
- Outperformance is rarely persistent—this year's winners are often next year's losers
Market Reactions:
- Stock prices adjust within minutes to earnings announcements
- Merger arbitrage opportunities disappear almost instantly
- Index inclusion effects occur immediately upon announcement
Challenges to EMH (Market Anomalies)
| Anomaly | Description | Challenge to EMH |
|---|---|---|
| January Effect | Small stocks outperform in January | Predictable pattern should not exist |
| Momentum | Recent winners continue winning short-term | Past returns shouldn't predict future |
| Value Premium | Low P/B stocks outperform long-term | Publicly available info shouldn't provide edge |
| Small-Cap Effect | Small stocks outperform large (historically) | Size is public information |
| Market Bubbles | Prices deviate dramatically from fundamentals | Prices should reflect fair value |
Behavioral Finance Critique
Behavioral finance argues that:
- Investors are not always rational
- Cognitive biases lead to systematic errors
- Markets can remain irrational longer than you can remain solvent
- Examples: Overconfidence, herding, loss aversion, anchoring
Investment Implications
If You Believe Markets ARE Efficient:
| Strategy | Rationale |
|---|---|
| Passive indexing | Can't beat the market, so match it |
| Minimize costs | Fees reduce returns without adding value |
| Focus on asset allocation | Primary driver of long-term returns |
| Tax efficiency | One area you can control |
| Broad diversification | Don't try to pick winners |
If You Believe Markets Are INEFFICIENT:
| Strategy | Rationale |
|---|---|
| Active management | Skilled managers can exploit mispricings |
| Research and analysis | Information analysis can add value |
| Concentrated positions | High-conviction ideas can outperform |
| Factor investing | Exploit known anomalies |
The Practical View
Most investment professionals take a middle ground:
- Markets are mostly efficient, most of the time
- Some inefficiencies exist, especially in less-followed markets
- Active management can add value, but it's difficult and costly
- A combination of passive (core) and active (satellite) may be optimal
On the Exam
Series 65 frequently tests:
- Identifying which form of EMH is described in a scenario
- Understanding what analysis is useful under each form
- Recognizing investment implications of market efficiency
- Knowing that strong form is NOT supported by evidence
Key Takeaways
- EMH claims prices reflect available information
- Weak form: Past prices reflected—technical analysis useless
- Semi-strong: All public info reflected—fundamental analysis useless
- Strong form: All info reflected—NOT supported by evidence
- Most active managers underperform their benchmarks
- If markets are efficient, passive indexing is the logical choice
According to the semi-strong form of EMH, which type of analysis could potentially produce excess returns?
If markets are efficient, an investor's best strategy would be:
Which form of the Efficient Market Hypothesis is generally NOT supported by empirical evidence?
9.4 Risk & Performance Measures
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