Efficient Market Hypothesis (EMH)

Financial Market Theory

The Efficient Market Hypothesis is one of the most influential and debated theories in finance. It basically says that the price of any asset reflects ALL avaible information at any given time, meaning that no one can consistently beat the market. (obviously, some people can, which is what brings up the AMH, which we'll talk about later)

Efficient Market Hypothesis (EMH)

The EMH creates a level playing field where everyone in the market all have the same access to the same information, and prices are always where they should be, because they incorporate all knowledge about the asset.

Core Idea:

• All the available information is reflected in current asset prices
• Prices adjust instantly when new information surfaces
• Past price movements cannot be used to predict future prices reliably
• Says that it's impossible to consistently achieve returns exceeding average market returns(like an index fund, again why outcompeting something like the SPY is so hard), adjusting for risk

Example:

• Imagine a stock trading at $100, like AAPL
• All available information about the company (earnings, competitors, new products, etc.) is already incoporated into that $100 price
• No investor can consistently "beat the market" on AAPL, because new information is immediately factored right into the price
• If you discover any new information, so do thousands of other traders at almost the same time, and your edge disappears.
• By the time you can act, the price has already adjusted, and is now where it should be, reflecting the information available.

Three Forms of EMH:

• Weak Form: Historical prices and trading volume are fully reflected in the price, so technical analysis won't work
• Semi-Strong Form: All publicly available information is reflected in prices, so fundamental analysis won't give an edge
• Strong Form: All information (public and private) is reflected in prices, so even insider information won't help

Why It Matters:

• Implication 1: Active fund managers rarely outperform index funds, like SPY, consistently
• Implication 2: Stock picking based on research is unlikely to beat the overall market long-term
• Implication 3: Markets are generally rational and self-correcting, so finding an edge is impossible

Criticisms:

• Behavioral Finance: Humans aren't always rational, so cognitive biases can affect prices(kinda idea behind AMH)
• Market Anomalies: Patterns like the "January Effect" or cross-asset suggest markets aren't always efficient
• Real-world Examples: Bubbles and crashes show prices can change from its real price(idea shared by Michael Burry, famous investor)

Key Foundational Research:

All this research is super cool for this idea, and is fun to dive into if you're interested!

1. Eugene Fama (1970): "Efficient Capital Markets: A Review of Theory and Empirical Work" - The paper that made the EMH and its three forms. Read the paper

2. Burton Malkiel (1973): "A Random Walk Down Wall Street" - Popularized EMH with a "random walk" concept, basically saying that picking stocks that outperform the market is like throwing darts

3. Paul H. Cootner (1964): "The Random Character of Stock Market Prices" - Foundational work on the random walk hypothesis, showing that stock price changes are random and unpredictable. Read the paper