Efficient Market Hypothesis (EMH)
The Efficient Market Hypothesis proposes that stock prices fully reflect all available information, making it impossible to consistently outperform the market through stock selection or market timing.
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Exam Tip
Know the 3 forms: Weak (past prices), Semi-Strong (public info), Strong (all info). EMH supports passive/index investing.
What is the Efficient Market Hypothesis?
The Efficient Market Hypothesis (EMH), developed by Eugene Fama, suggests that financial markets are "informationally efficient"—meaning current prices already incorporate and reflect all relevant information.
Three Forms of EMH
| Form | Information Reflected | Beating Market With |
|---|---|---|
| Weak | Past prices and volume | Technical analysis: No |
| Semi-Strong | All public information | Fundamental analysis: No |
| Strong | All public AND private info | Insider info: No |
Implications of EMH
| If EMH is True | Then |
|---|---|
| Stock Picking | Won't consistently outperform |
| Market Timing | Won't work reliably |
| Index Funds | Best choice for most investors |
| Active Management | Hard to justify fees |
Evidence For EMH
| Evidence | Explanation |
|---|---|
| Professional Underperformance | Most active funds underperform indexes |
| Random Walk | Price changes appear random |
| Rapid Adjustment | Prices quickly react to news |
Challenges to EMH
| Challenge | Explanation |
|---|---|
| Market Anomalies | January effect, momentum, size effect |
| Behavioral Biases | Investors make irrational decisions |
| Warren Buffett | Long-term outperformance examples |
| Market Crashes | Prices deviate from fundamentals |
Practical Implications
| Strategy | EMH Support |
|---|---|
| Passive Investing | Supported by EMH |
| Diversification | Important regardless of EMH |
| Low-Cost Funds | Supported by EMH |
| Active Trading | Not supported by EMH |
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