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Efficient Market Hypothesis

The efficient market hypothesis (EMH) was created by Noble prize winner, Eugene Fama. It suggests that security prices always fully reflect all available information. In other words, you can’t beat the market because the efficiency of the market takes all available information into account.

Like most market theories, EMH is highly controversial. Those who believe in the theory say it is pointless to search for undervalued stocks or predict trends and that fundamental and technical analysis useless.


3 Efficiencies

EMH says there are 3 types of market efficiency, weak, semi-strong and strong. The weak version simply says stock prices reflect all publicly available information. The semi-strong form of stock market efficiency includes the weak form but adds a stipulation that stock prices also adjust quickly to the release of additional information. The point of this is that prices adjust so rapidly investors can’t profit from analysis.

The final form of EMH, the strong form, includes both the weak and semi-strong adds insider information. The problem is that if strong form were true, investors would not be able to profit from insider information. In fact, they can, although it is illegal to do so.

So, we’ve ruled out the possibility that markets are “strong form” efficient, but are they weak or semi-strong form efficient?

What Is True

Many experts and analysts argue that EMH could not possibly be true based on evidence they say suggests markets move away from a fair price to create overvalued and undervalued scenarios. There are many examples of this including the internet bubble of the late 1990’s. Currently, many analysts believe stocks, in general, are overvalued.

Another issue, market anomalies, create a problem for EMH. An anomaly occurs when a stock or group of stocks perform contrary to the notion of efficient markets. One anomaly is momentum. Another is the fact that lower valued stocks usually appreciate more than overvalued stocks. Also, small-cap stocks typically outperform large cap stocks and then there is the January effect, a time when stocks typically go up.


Counter Arguments

There are counter arguments to most anomalies. Momentum, for example, eventually stops. Many experts say that over time, investing in index funds will yield superior results to trying to time the market at least for most people.

Stocks have averaged 9% over the past 80 years. Bonds have averaged 5%. Your chances of outperforming those numbers are slim. If you want to try, have at it, but perhaps it would be wise to keep your stake small – say 10 to 15% of assets.

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