BAJAJ BROKING
August 30, 2024
5 mins read
Proposed by the American economist Eugene Fama, the efficient market hypothesis suggests that investors cannot beat the market consistently over a long period of time. As per this hypothesis, all the information about a security is already factored into its price. Hence, investors cannot outshine each other by either analysing it better or timing it better. This theory assumes that there are no transaction costs in the market, investors are always rational, and information does not come at a cost. While these assumptions hold true to a large extent in real life, they do not always hold true.
The efficient market hypothesis (EMH) is one of the most popular theories of the financial market. As per EMH, a security's price reflects all sorts of information available about it. In other words, all securities always trade at their fair value in the market. Hence, the market is always efficient. Therefore, the market does not have under-valued or over-valued stocks, as all stocks trade at their fair value. This hypothesis was developed by American economist Eugene Fama. In simple words, the efficient market hypothesis suggests that investors cannot generate higher returns than the market. The only way they can do that is by buying securities with a considerably higher risk. Having learnt what the efficient market hypothesis is, let’s delve deeper into this topic.
There are three forms of this hypothesis:
Weak Form: As per this, the stock price of a stock today reflects its past prices perfectly. Hence, technical analysis cannot help people buy or sell a stock. However, fundamental analysis (which is based on a company's financials) can help people find over and under valued stocks. Using which, investors can make a higher return than the market.
Semi-Strong Form: This approach argues that a stock's price reflects all information available about it publicly. Hence, neither technical nor fundamental analysis can help investors beat the market. The only way to earn a higher return than the market is by having access to information that is not publicly available.
Strong Form: As per this version, all sorts of information, whether publicly available or not publicly available, is factored into stock prices. Hence, investors can never earn a higher return than the market.
The efficient market hypothesis is based on certain assumptions. First, transaction costs don’t exist in the market. If these costs exist, then even if two investors have exactly the same information, they may not generate the same returns. Second, information does not have a cost. If not for this, an investor may pay more for certain information than his peers and hence generate less returns than others. Third, all investors have exactly the same expectations from a security. Fourth, investors are totally rational.
We only have to look at the assumptions behind this hypothesis to understand the arguments for and against EMH. Most assumptions behind EMH hold true to an extent but not entirely. Hence, those who argue for it cite the extent to which these assumptions hold true in the real world, while those who argue against it cite instances when these assumptions don’t hold.
For example, this hypothesis proposes that all investors have exactly the same information. Several trading scandals have happened worldwide in the last few decades, which show that certain traders knew more about a stock than most other traders. Hence, this assumption is true but only to an extent.
Similarly, EMH assumes that transaction costs don’t exist in the market. Over the years, transaction costs have come down; however, they still exist. This assumption, too, holds but only to an extent.
This hypothesis rests on the assumption that no one can beat the market consistently over a long period. Hence, it suggests that investors should hold a diversified portfolio that mirrors the composition of the market. Therefore, as per this theory, investors can invest in an index fund because they are unlikely to beat the market by actively managing their own investments. Hence, they should adopt a passive approach by investing in an index fund that has the same composition as the stock market.
While the efficient market hypothesis has its merits, it also has its limitations. For example, it assumes that all investors are rational. In reality, all investors cannot be rational all the time. When the stock market moves up or down significantly, many investors make a decision to buy or sell a stock with a huge trading volume purely based on their emotions. Besides, this hypothesis is unable to explain how certain anomalies happen in the market. Let’s take the case of the January effect, as per which stocks tend to perform better in January than in other months. EMH cannot explain this effect.
This hypothesis has several practical applications. You can apply it by investing in an index fund or having a passive strategy. You can invest in an index fund that holds stocks in the same proportion as an index like Nifty. As a result, you don’t have to worry about picking stocks yourself and yet you earn the returns generated by the fund, which mirrors the market. EMF has a practical application for regulators, too. This hypothesis clearly shows how markets function with transparency and absolute information symmetry. Hence, regulators can use its insights to formulate policies that ensure the highest level of transparency in the market.
As per the efficient market hypothesis, no one can beat the market consistently over a long period. Hence, people are advised to invest in a well-diversified index fund that has the same composition of stocks as an index like Nifty. This is a passive approach towards investment because it allows people to invest in an index fund, rather than actively selecting stocks. On the other hand, active management requires investors to actively select stocks themselves to purchase or sell.
If you are just beginning to trade and have just opened a new demat account, it’s not difficult to learn the meaning of the efficient market hypothesis. However, applying it in real life can be a bit tricky. At times when the market swings crazily, some investors may think that this hypothesis doesn’t apply. However, it does apply to a large extent over a long period. In other words, it’s extremely difficult for anyone to earn a higher return than the market over the long run without taking a considerably higher risk than the market.
Disclaimer: Investments in the securities market are subject to market risk, read all related documents carefully before investing.
This content is for educational purposes only. Securities quoted are exemplary and not recommendatory.
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This hypothesis proposes that the market is always efficient. Hence, no one can generate a better return than the market consistently over a long period.
There are three forms of this hypothesis: weak, semi-strong, and strong.
As this hypothesis proposes that you can’t generate a higher return than the market, it suggests that you can invest in an index fund, which mirrors the market. Hence, it advocates the passive approach of investment.
This hypothesis assumes that all investors are always rational. This is not true. Often investors take a decision in the grip of an emotion, particularly when the market is swinging crazily.
Investors can apply this hypothesis by not actively buying and selling securities. Instead, they can adopt the passive approach by investing in an index fund that mirrors an index in terms of stock composition.
Take the case of the January effect, wherein stocks usually provide better returns in the month of January than in other months. The efficient market hypothesis cannot explain this phenomenon.
As per behavioural finance, investors are not always rational and hence the market cannot always be efficient. Behavioural finance suggests that the cognitive biases of investors often result in irrational decisions.
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