The efficient market hypothesis (EMH) is a concept that suggests that the prices of securities traded in the market incorporate all available information about a financial instrument. EMH is a highly debated topic in modern economic theory. Assuming that the efficient market hypothesis is error-free, market values should only react to new information, which makes it nearly impossible for any one value to gain an advantage in the market. According to EMH, stocks always trade at their true values in the markets, which means that investors will buy a stock at its actual price. Therefore, it is almost impossible to trade a financial product at undervalued or inflated prices. The only way for an investor to earn high profits is by making risky investments.
What Are the Three Variations of the Efficient Market Hypothesis?
Individual investors who truly believe in the efficient market hypothesis determine passive investment strategies that demonstrate comparison. The main forms of the efficient market hypothesis are:
- The Weak Form Efficiency
- The Semi-Strong Form Efficiency
- The Strong Form Efficiency
The Weak Form Efficiency
Investors who believe in EMH think that securities represent all market data. Conversely, those who believe in the weak form of the hypothesis think that price information does not reflect current data that is not disclosed to the public.
Investors who believe in the weak form of the hypothesis think that past prices do not influence future prices. With the weak form of the efficient market hypothesis, a good fundamental analyst can identify and select stocks that perform well in the short term by anticipating that new emerging data can affect prices.
The Semi-Strong Form Efficiency
The semi-strong form of the hypothesis suggests that new public information is simultaneously reflected in the market. This means that technical or fundamental analysis techniques cannot be used.
The Strong Form Efficiency
In the strong form of the hypothesis, it is believed that all private and public information encompass a security's current value.
What Are the Advantages of the Efficient Market Hypothesis (EMH)?
The efficient market hypothesis requires that stocks and cryptocurrencies should not be approached speculatively, and should not be seen as a way to make more profits, aiming to protect investors.
EMH advocates that markets are efficient. It allows for savings in time spent calculating profit/loss ratios, analyzing technical dashboards, and measuring balance sheets.
Limitations of the Efficient Market Hypothesis
Since its first application in the 1960s, several limitations of EMH have emerged, which are as follows:
- Market Corrections
- Market Anomalies
- Behavioral Economics
Market Corrections
An economic bubble can arise when a financial product rises above its fair value and market corrections occur. This can lead to a rapid decline in prices, resulting in a market crash.
Market Anomalies
Market anomalies refer to a difference between the price determined by EMH and the actual price. This can occur at any point in time.
Behavioral Economics
Behavioral economics does not assume that market participants are rational individuals. It argues that difficult conditions can cause individuals to experience stress and struggle to make correct decisions.
Assumptions of the Efficient Market Hypothesis (EMH)
EMH is based on certain assumptions. These assumptions are as follows:
- Stocks trade at fair prices in markets.
- EMH argues that the market price of stocks reflects all available information.
- It advocates that investors make decisions based on available information.
What Does Market Efficiency Mean?
Market efficiency refers to how values reflect all available information. EMH argues that markets are efficient, fair, and do not leave room for making more profit by investing properly.
