What is Efficient Market Hypothesis (EMH)?

Published by Thomas Herold in Economics, Investments, Trading

'Efficient Market Hypothesis (EMH)' is explained in detail and with examples in the Economics edition of the Herold Financial Dictionary, which you can get from Amazon in Ebook or Paperback edition.

The efficient market hypothesis is also known by its acronym EMH. It refers to an investment theory which claims that investors can not outperform the stock markets practically on a consistent basis. This is because the efficiencies created by the inner workings of the stock market mean present day share prices will always reflect and incorporate all relevant and practical information.

The idea states that stocks will practically always sell for their true fair value on the various stock exchanges. This infers that the typical investor can not efficiently buy undervalued shares or sell them at overly high prices. This is why it is theoretically impossible for investors to better the ultimate return of the stock markets no matter how expertly they select stocks or how well they time the markets. Efficient market hypothesis claims that the only means of outperforming the markets is through buying investments with higher risk and therefore coming with accompanying better returns.

Despite the fact that this efficient market hypothesis remains a foundation of modern day financial theories, it is still regarded with suspicion and controversy. Many investors and especially stock picking fund managers consistently defy it and try to select their own stocks. Those who concur with the EMH theory state that stock pickers are wasting their time in an effort to track down undervalued shares, or in predicting market trends, using either technical or fundamental analysis.

Clearly the economists and other scholarly individuals can hold up a significant amount of evidence that supports the efficient market hypothesis. Despite this, a broad range and variety of arguments against it still exist. Legendary investing stock pickers like Warren Buffet have managed to outperform the markets year in and year out over many decades. This should not be consistently possible at all by the arguments and logic of the EMH.

Other critics of the efficient market hypothesis hold up such Black Swan Events as the Black Monday 1987 crash in the stock markets. On this particular occasion, the DJIA Dow Jones Industrial Average plunged by in excess of 20 percent in only one day. This does raise a valid point about stock prices and how efficiently they are always valued when they can suddenly fall by a fifth of their value in only hours.

Believers in this efficient market hypothesis argue that markets are both efficient and random. This means that investors should be able to make their best consistent returns by choosing to invest in low fee, unmanaged, broadly representative portfolios. Morningstar Inc., the famous market research firm has compiled a great amount of data to support this assertion. They compiled the returns of active fund managers in every category. Then they held these up versus an index of relevant funds or ETF exchange traded funds. The study concluded that for any year to year period, there were merely two different groups of active fund managers who managed to consistently outperform the passively held funds over half the time. The two that outperformed were the diversified emerging markets funds and the small growth funds.

As far as all of the remaining categories such as U.S. large value, U.S. large blend, and U.S large growth (and most others), those who invested in either ETFs or lower cost index funds would have made higher returns. It is true that a small percentage of the active fund managers do manage to realize superior performances versus the passively managed funds at times and points. The problem that this presents for individual investors lies in predicting which fund managers will do this. Fewer than a quarter of the best performing active fund managers can outperform their passive manager benchmark funds consistently. Certainly Warren Buffet counts as one of those most successful few. It helps to explain his enduring popularity and success with investors for decades now.

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The term 'Efficient Market Hypothesis (EMH)' is included in the Economics edition of the Herold Financial Dictionary, which you can get from Amazon in Ebook or Paperback edition.