Efficient Market Hypothesis (EMH): Does It Hold True In Stock Market?

 Flabia Maharjan

What is Efficient Market Hypothesis (EMH)?

The arrival of new information is the most significant factor for bringing about changes in stock prices. The Efficient Market Hypothesis (EMH) states that any new information that arrives in the market is quickly mirrored in the stock prices. So, neither technical analysis (study of past stock prices and its patterns) nor fundamental analysis (study of a company’s financial information) can generate excess returns for an investor in comparison to another investor who has a portfolio of randomly selected stocks. Thus, EMH questions the predictability of the stock market.

The cutthroat competition between investors to benefit from new information is considered to be the main reason behind an efficient market.  Investors look for mispriced stocks to buy stocks for less than their real value and sell other stocks for more than their actual worth. However, as the numbers of analysts that try to identify overvalued and undervalued stocks increase, the likelihood to profit from mispriced stocks becomes extremely small. Only a small number of analysts will benefit by identifying mispriced securities, while a majority of the investors will be at a loss since transaction costs will be greater than the analysis payoff.

Now, there’s a big question regarding why the market participants would be making their investment decisions based on such analyses if they were of no use to outperform the market, some of which we will discuss in this article.

Forms of Efficient Market Hypothesis

The Efficient Market Hypothesis holds that the security prices reflect “all the available information” at any given point. What “all the available information” refers to changes according to the form of the EMH.

1. Weak Form Efficiency

The weak form of the market efficiency hypothesis states that the current prices reflect all the information related to past stock prices. Hence, the study of historical prices and patterns along with trading volume cannot determine mispriced stocks. This is because the security prices are the most public and easily available piece of information. It is hard to benefit from something that everyone knows. In other words, technical analysis does not help an investor outperform the market since the past rate of return has no relationship with the current rate of return.

2. Semi-Strong Form Efficiency

The semi-strong form of market efficiency hypothesis states that the current prices have adjusted to all the publicly available information. Along with past stock prices, public information includes a company’s financial statements (annual reports, income statement, etc.), dividend and earnings announcements, announced merger plans, the financial position of competitor companies, etc. Like weak form efficiency, semi-strong form efficiency asserts that nobody can benefit from the information known to all (public information). The only difference is that the assumption of semi-strong form efficiency is much stronger than weak form efficiency. Thus, no one can outperform the market with fundamental and technical analysis as per this form of efficiency.

3. Strong Form Efficiency

The strong form of market efficiency hypothesis states that both public and private (insider) information are fully reflected in the prices of the securities. No one can outperform the market even if they have access to private and inside information which has not been announced to the public yet. In other words, a company’s management (insiders) will not profit from purchasing the company’s shares after they’ve decided to go for an acquisition that they perceive will be profitable. Nor will the research department gain from the information of a breakthrough discovery they made. Strong Form Market Efficiency asserts that the market anticipates future developments in an unbiased manner. Therefore, the stock prices may have incorporated and evaluated the information objectively than the insiders.

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 Evidence against the EMH

 1. Behavioral Finance: Rationality vs. Irrationality

Behavioral Finance establishes an argument against the efficient market hypothesis. EMH states that the prices of stocks will reach equilibrium since all available information reaches investors at the same time. Thus, it argues that all investors make rational investment decisions. Although behavioral finance supports the assumption that all investors receive information and news simultaneously, it regards investment decisions of investors as a product of their way of analyzing the information. Hence, behavioral finance claims that several psychological and emotional biases will lead investors to make irrational decisions. One of the common behavioral biases is the loss aversion bias, where investors will hold onto a position although it has caused the investor massive losses and will continue to do so. They are only willing to sell it once the prices rise. Hence, investors get emotionally attached to their investments which does not allow them to exit harmful investments at the right time. This is just one of the several biases that lead investors towards irrationality.

2. Overreaction and Underreaction

According to EMH, investors react rationally to new information; however, studies have found that individuals overreact to current information and underreact to past information. This results in mispricing of stocks; thus, confirming that the overreaction hypothesis is predictive. Future earnings announcements are significantly correlated with the stock price movements. Stock prices of companies with positive earnings tend to move upward, and those with negative earnings tend to move downward as investors tend to overreact to good news and bad news, respectively. As noted in Theory of Investment Value, “prices have been based too much on current earning power and too little on long-term dividend-paying power.” This can further be explained by the price to earnings (P/E) ratio anomaly. Stocks with a low P/E ratio reflect that they are undervalued and show a higher risk-adjusted return over stocks with a high P/E ratio which are thought to be overvalued. Thus, demand significantly increases with respect to how much individuals think they can benefit from their investment with the available information. And overreaction and underreaction are a result of the investor’s emotion.

In an efficient market, stock prices reflect all the available information, and it is impossible to beat the market using past data. Thus, predicting the returns using past data challenges the idea of market efficiency. Empirical studies show that loser portfolios outperform winning portfolios in the long run, and this reversal effect is attributed to investor overreaction. Similarly, studies show that winners continue remaining winners and losers continue remaining losers in the short run. This is the momentum effect attributed to underreaction. Hence, the “Overreaction” and “Underreaction” phenomena challenge the validity of market efficiency. It is because these ideas assert that investors are likely to make profits either by “buying past losers and selling past winners (contrarian strategies)” in the long run or by “buying past winners and selling past losers (momentum or relative strength strategies)” in the short run, respectively.


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3. Fair Pricing

EMH states that the stock prices in the market are “fairly priced” and the decisions of the investors are reflected in the market price. However, the behaviors of the investors are not uniform. Just as humans have different perceptions and their likes and dislikes vary, investors in the market too can pursue different investment strategies due to differences in preferences. Some may invest in high-risk portfolios, while others may opt for less risky investment strategies. Investors have different investment goals as their knowledge and way of thinking are not the same, which results in a variance in the investor profile. An argument against EMH is that it is impossible to determine a stock’s worth under an efficient market since investors value their stocks differently.

4. Against Strong Form Efficiency

The strong form efficiency hypothesis states that the current price reflects all available private and public information, including inside information, which is accessible to the management of the company. As per this hypothesis, insiders or the management won’t profit from the information they know before making a public announcement. However, suppose a department is aware of a breakthrough discovery they’ve made that is perceived to be profitable. In that case, it won’t take much time for this information to reach the ears of people outside the company.  This way, the outsiders can also gain profit from the information by purchasing shares of the company before this information is publicly announced. If the strong form efficiency hypothesis were correct, insiders shouldn’t profit by trading on private information. However, some studies have found considerable evidence that insider trading is profitable.

5. Professional Investment Managers, Mutual Funds Consistently Outperforming the Market

Investors tend to use various forecasting and valuation techniques to detect mispriced securities that will outperform the market. However, EMH states that none of these techniques are effective, and thus, no one can predictably outperform the market.

Conversely, there is evidence of professional investment managers and mutual funds outperforming the market for a very long time with the help of technical and fundamental analysis. Individual investor Warren Buffet has outperformed the market by purchasing undervalued stocks and made billions through it. There are portfolio managers with higher track records than others and investment houses with better research analyses than others. The supporters of the EMH claim that individuals outperform the market due to the law of probability, which states that in a market full of actors, some will outperform the mean, while some will underperform at any given time.

6. Value Vs. Growth

EMH states that the market cannot be outperformed as the prices quickly adjust to any new information available in the market. Value strategies involve buying stocks with low prices relative to their accounting “book” values, dividends, or historical prices. They have the ability to outperform the market. A significant difference has been observed between the average return on stocks with a low price to book ratio (value stocks) compared to stocks with a high price to book ratio (glamour stocks). Market participants consistently overestimate the future growth rates of glamour stocks relative to value stocks. These results depict strong evidence against EMH.

Also Read: Dividend Stocks Vs Growth Stocks: Which Is Better Investing Strategy?


Most empirical evidence supports weak and semi-strong forms of the efficient market hypothesis which convey that investors don’t have much to gain from active management strategies. Such attempts to outperform the market are worthless and could additionally reduce returns due to costs incurred. However, the Efficient Market Hypothesis lacks uniform acceptance, and many investment professionals still view EMH with skepticism due to the aforementioned evidence.

From The Author:

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