All About Efficient Market Hypothesis

An increasing number of investors and traders use technical and fundamental analysis techniques to determine the price movements of assets in the future and present. Although these techniques are widely accepted as being useful in planning trading strategies, there is another group of traders that believe in the efficient market hypothesis. Here's what you need know about this concept.

What is an efficient market hypothesis (EMH), and how does it work?

The efficient market hypothesis, also known as market efficiency theory or market efficiency theory, assumes that all information relating to an asset has been factored into the current price. This basically means that assets trade at their fair value and it is impossible to identify undervalued stocks.

According to the efficient market hypothesis, any new information relating to assets is immediately accounted for by market. This hypothesis assumes that the market can quickly factor in new information to determine the asset prices. It states that no matter how many analytical tools you use, trading or investing, it is impossible to beat the market.

Efficient Market Hypothesis : An example

Let's look at an example to better understand the concept.

Let's say there is a stock in a company called ABC Limited. Current trading price of the shares is Rs. 100 per share. After conducting a detailed analysis of the company, including looking at its financial statements for the past year, you conclude that it is performing well. Finally, you decide to purchase its shares.

In another scenario, you might consider that instead of trying determine whether the current share price for Rs. 100 is too high or low, you will assume that it is fair value. 100 is undervalued or overvalued, the current price of Rs. 100 is assumed to be the stock's fair value. This assumes that Rs. 100 per share already considers the company's financial performance. Any further increase in stock price above Rs. 100 will only occur if there is any unexpected positive news or new developments.

This assumption is exactly what the market efficiency theory says. The market already accounts for past and current performance, so future stock price increases would not be caused by it.

Market efficiency Theory

There are three main types of variations in the efficient market hypothesis. Let's take a closer look at each one.

Weak

This variation of market efficiency theory states that an asset's value has already taken into account all information available to the public. The asset's price may not include any new information that is not yet available to the public.

Another assumption that the weakest form of efficient market hypothesis makes, is that historical information about an asset doesn't have any impact on its future price movements. This variation ignores technical analysis completely, but allows for fundamental analysis.

Semistrong form

Another type of market efficiency theory is the semi-strong variant. This variation basically builds on the assumptions of the weak form. This variation basically states that any new information regarding an asset that is made public is almost always immediately factored in to its market prices.

This form ignores both technical analysis and fundamental analysis. This is evident in the RBI's monetary policy on the repo rate. The markets immediately react to the repo rate announcement by adjusting their stock prices in line with it.

Strong Form

This is the strongest variant of the efficient market hypothesis, as the name implies. This form assumes that asset prices reflect all information related to them, public or private.

This variation assumes that all past and current information, both public and private (the insiders), is assumed to be included in the asset's price. This basically means that no one can beat the market, even insiders.

Wrapping up

Although you might be tempted not to consider the concepts of technical and fundamental analysis, remember that an efficient market hypothesis is a theory. These assumptions are only valid in certain cases, and not all. It is important to recognize the importance of technical and fundamental analysis in helping you make informed decisions.