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EMH: An Introduction to the Efficient Markets Hypothesis

Learn about Efficient Market Hypothesis (EMH) today!

Are you familiar with Efficient Market Hypothesis? If not, you do not have to worry about it. Today, we will be discussing efficient market hypothesis or EMH.

You might be thinking why even the most experienced mutual fund portfolio managers and other professional investors often lose to the major market indexes.

Our discussion about efficient market hypothesis (EMH) will help you understand more about this investing phenomenon.

EMH infographic

What is Efficient Market Hypothesis?

Efficient Market Hypothesis or also known as EMH is an investment theory stating that it is impossible to “beat the market.” Since stock market efficiency can cause existing share prices to always incorporate and reflect all relevant information.

According to the EMH, stocks always trade at their fair value on stock exchanges, making it impossible for investors to buy undervalued stocks or sell stocks for inflated prices.

As such, it would be impossible to outperform the overall market through expert stock selection or marketing timing. The only possible way for an investor to get higher returns is to buy riskier investments.

In addition, the efficient market hypothesis essentially says that all known information about investment securities including stocks, is already factored into the prices of those securities. With this, there will be no amount of analysis can give an investor an advantage to other investors.

EHM actually does not require investors to be rational. It says that while individual investors can act randomly however, as a whole, the market is always “right.”

In much simpler terms, “efficient” indicates “normal.”

What are Efficient Markets?

Fundamental to modern portfolio theory, efficient markets are the basis that underpins financial decision making.

In early 1960s, Eugene Fama, a Nobel Prize winning economist, has put forth the theory of efficient markets, which remains gathering acceptance throughout the field of finance.

According to the theory of Fama, fundamental are inherently efficient markets, rational expectations, and security prices reflecting all available information. The logic behind this is characterized by a random walk, where all subsequent price changes reflect a random departure from last prices.

There are a lot of investors who are trying to identify securities that are undervalued, and are expected to raise in value in the future, and particularly those that will increase more than others.

Since the share prices can instantly reflect all of the available information, then the tomorrow’s prices are independent of today’s prices and will only reflect tomorrow’s news.

In addition, it is important to know that the changes in news and price are unpredictable.

Therefore, a novice and expert investor, holding a diversified portfolio, will obtain comparable returns regardless of their varying levels of expertise.

Efficient Market Hypothesis Illustration

3 Forms of Efficient Market Hypothesis

EMH has three different forms that influence security values. These three forms are known as Weak Form Efficient Market Hypothesis, Semi-Strong Form Efficient Market Hypothesis, and Strong Form Efficient Market Hypothesis.

According to Fama, these three forms of market efficiency represent the distribution of news through different sources.

Weak Form Efficient Market Hypothesis

Weak form efficient market hypothesis suggests that all previous information is priced into securities. With fundamental analysis of securities, investors are provided with information to produce returns above market averages in the short term. However, there are no existing “patterns.”

Therefore, fundamental analysis does not offer long-term advantage and technical analysis will not work.

Semi-Strong Form Efficient Market Hypothesis

Semi-strong form efficient market hypothesis is indicates that neither fundamental analysis nor technical analysis can provide an edge for an investor and that latest information is instantly priced in to securities.

In this form, inventors are unable to gain irregular returns due to the market prices already reflecting public information.

Strong Form Efficient Market Hypothesis

The efficiency of strong form efficient market hypothesis is where all information, public, personal, and confidential is reflected in share prices.

As a result, investors are unable to attain a competitive advantage and deters insider trading. This degree of market efficiency implies that above average return cannot be attained regardless of an investor’s access to information.

The Shortcomings of Efficient Market

As the efficient market theory resonates throughout financial research, it has frequently fallen short in its application throughout history.

In 2008 Financial Crisis, various traditional financial theories have been challenged for their lack of practical perspective on the markets. If all the assumptions about efficient markets had held, then the housing bubble and subsequent crash would not have happened.

However, efficiency failed to explain market anomalies, such as speculative bubbles and excess volatility. As the housing bubble reached its peak and investors continuously pouring funds into subprime mortgages, irrational behavior started to precede the markets.

Contrary to rational expectations, investors have acted irrationally in favor of potential arbitrage opportunities. Still an efficient market would have automatically adjusted asset prices to rational levels.

As the theory failed to address financial downturns, it has often been challenged.

In theory, each individual is allowed to access and analyze information channels, including social media. Not even the most involve investors are unable to monitor every information.

With that being said, you should know that investment decisions tend to be influenced more by emotions instead of rationality.

Man Watching over a Graph on Computer

A Behavioral Method

As a new study, the behavioral finance started from the anomalies that the efficient markets cannot explain.

Behavioral finance pursues to incorporate cognitive psychology with conventional finance in order to provide an explanation for irrational investment decisions. As its core, behavioral finance is based on the notion that investors are subject to behavioral biases which influence less than rational decisions.

Meanwhile, behavioral based biases are coming from cognitive psychology and have been applied to financial markets.

There are four popular biases, such as overconfidence, anchoring, hindsight bias, and gambler’s fallacy.

Hindsight Bias

It is often said that “seeing is believing.” However, there are some certain situations that what you perceive is not necessarily a true representation of reality.

Coming from the roots of basic psychology, hindsight bias is the belief that previous events were predictable and should have been acted on at the time.

In some various cases, hindsight is a form of rationalizing past errors and can lead to overconfidence.

Overconfidence

Overconfidence can be applied outside of finance.  However, in the field of investing, overconfidence is an investor’s intuition to overestimate their ability to process information and choose winning stocks.

You should know the line between confidence and overconfidence. Confidence implies realistically trusting in one’s abilities. Meanwhile, overconfidence usually implies an overly optimistic assessment of one’s knowledge or its control over a situation.

Gambler’s Fallacy

Meanwhile, when it comes to probability, a lack of understanding can lead into incorrect assumptions and predictions about the onset of events. Gambler’s fallacy is one of these incorrect assumptions.

In gambler’s fallacy, an individual erroneously believes that the onset of a certain random event is likely to happen following an event or a series of events.

For example flipping a coin, when you flip a coin, there is a 50 percent possibility of the coin turning up heads or tails. Just like in investing, individuals will fail to recognize that previous events are independent of the future.

Anchoring

Just like a house build on a solid foundation, our ideas and opinions should also be relevant and correct.

However, this is not always the case. The concept of anchoring draws on our tendency to attach our thoughts to a reference point, other times our initial decision, and refuse to waver regardless of access to new information.

It might seem unlikely phenomenon, anchoring is prevalent in situations where people are dealing with concepts that are new and original.

While these are just some of the most frequently exhibited phenomena, many other biases may appear in your decision-making. Taking investors bias’s into account, stock mispricing can arise in predictable fashions, giving credibility to an active manager’s ability to identify sources of mispricing.

Moreover, markets clearly do not price assets as rationally as an efficient market would claim. By identifying you biases and working to recognize your mistakes, understand other people’s decision will have lasting effects on your investment choices.

Many concepts of behavioral finance have a tendency to contradict the foundations of efficient markets. With that being said, efficiency shout not be discounted altogether. You future decisions and research should approach the market from an electric standpoint.

By knowing these biases, you can now apply this new information to your own investing.

Coins with Graph on the Background

Conclusion

Knowing the pros and cons of multiple theories can help you comprehend new information. If you have new information it could also help you make the best investing decision.

Just remember, if you want your investment choices to have more lasting effect learn to recognize your mistake. Do not make the same mistake over and over again.

You should also do your research to make your future financial decisions be more rational and more rewarding.

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