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Efficient Market Hypothesis: A Way to Beat Market Returns?

Efficient Market Hypothesis: A Way to Beat Market Returns?

Following up on 4 Notable Market Bubbles in History, this week we’ll discuss the efficient market hypothesis (EMH). Developed from a Ph.D. dissertation by economist Eugene Fama in the 1960s, the efficient market hypothesis states that markets are efficient and asset prices reflect all available information.

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The efficient market hypothesis (EMH) exists in three forms: weak, semi-strong and strong. It suggests that share prices reflect all relevant information, and that it is impossible to beat the market or achieve above-average returns on a sustainable basis and that the pursuit of market-beating performance is more about chance than it is about researching and selecting the right stocks.

Believers argue it is pointless to search for undervalued stocks or to try to predict trends in the market through either fundamental or technical analysis.

Warren Buffett is said to be critical of the efficient market hypothesis. Using his value investing approach, Berkshire Hathaway, the conglomerate that holds his investments, has often outperformed the S&P 500 over the past 52 years

The biggest piece of evidence to refute the efficient market hypothesis is the existence of market bubbles and crashes.

There are three levels, or degrees, of the efficient market hypothesis: weak, semi-strong, and strong.

  • The weak form assumes that current stock prices reflect all available information, and that past price performance has no relationship with the future. This form of the hypothesis says that using technical analysis to achieve exceptional returns is impossible. Those following the weak form of the hypothesis assume that prices might not reflect new information that hasn’t yet been made available to the public.
  • The semi-strong form says that stock prices have factored in all available public information, but not non-public. Because of this, it's impossible to use fundamental analysis to choose stocks that will beat the market's returns. It takes the same assertions of weak form, and includes the assumption that all new public information is instantly priced into the market. In this way, neither fundamental nor technical analysis can be used to generate excess returns.
  • The strong form of the efficient market hypothesis says that all information -- public as well as private -- is incorporated into current stock prices. Strong form efficient market hypothesis followers believe that all information, both public and private, is incorporated into a security’s current price. In this way, not even insider information can give investors an opportunity for excess returns.

Investors who follow the efficient market hypothesis tend to stick with passive investing options, like index funds and exchange-traded funds (ETFs) that track benchmark indexes.

Results seem to suggest that some markets are less efficient than others. It’s up to individual investors to weigh the evidence on both sides and to reach a conclusion about the efficiency of the financial markets that best matches their investing beliefs.

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