What is the Efficient Market Hypothesis?

By Markets Fool.com

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The efficient market hypothesis states 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. There are many critics of this theory, such as behavioral economists, who believe in inherent market inefficiencies.

The background and idea behind the efficient market hypothesis

The efficient market hypothesis was developed from a Ph.D. dissertation by economist Eugene Fama in the 1960s, and essentially says that at any given time, stock prices reflect all available information and trade at exactly their fair value at all times. Therefore, it is impossible to consistently choose stocks that will beat the returns of the overall stock market. Basically, the hypothesis implies that the pursuit of market-beating performance is more about chance than it is about researching and selecting the right stocks.

Three variations

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

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The weak form assumes that current stock prices reflect all available information, and that past price performance has no relationship with the future. In other words, this form of the hypothesis says that using technical analysis to achieve exceptional returns is impossible.

The semi-strong form says that stock prices have factored in all available public information. Because of this, it's impossible to use fundamental analysis to choose stocks that will beat the market's returns.

Finally, the strong form of the efficient market hypothesis says that all information -- public as well as private -- is incorporated into current stock prices. This form of the efficient market hypothesis essentially assumes a perfect market, and isn't plausible when there are insider trading restrictions.

Criticisms of the hypothesis

Perhaps the biggest piece of evidence to refute the efficient market hypothesis is the existence of market bubbles and crashes. For example, if the assumptions of the hypothesis were correct, the housing bubble and stock market crash of 2008 wouldn't have happened. The same can be said about the tech bubble of the late 1990s, when many tech companies were trading for sky-high valuations before crashing.

Also, there are some investors who have consistently beaten the market. As a famous example, Warren Buffett has been highly critical of the efficient market hypothesis. Using his value investing approach and trying to identify a margin of safety in stocks, Buffett has achieved returns that have been far superior to those of the market -- and he's done it steadily over a 50-year period of time.

Behavioral economists are also major critics of the efficient market hypothesis. In a nutshell, the study of behavioral finance is based on the assumption that investors are susceptible to certain biases, such as the belief that past performance is indicative of the future. These biases can lead to mispricings in stocks, according to proponents.

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