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What is the Efficient Market Hypothesis?

[By Jeffrey S. Coons; PhD, CFA]

[By Christopher J. Cummings; CFA, CFP™]

The Efficient Market Hypothesis (EMH) states that securities are fairly priced based on information about their underlying cash flows and that physician investors should not expect to consistently outperform the market over the long-term. 

 EMH Types 

There are three distinct forms of EMH that vary by the type of information that is reflected in a security’s price:

·  Weak Form: This form holds that investors will not be able to use historical data to earn superior returns on a consistent basis.  In other words, the financial markets price securities in a manner that fully reflects all information contained in past prices.

·  Semi-Strong Form: This form asserts that security prices fully reflect all publicly available information. Therefore, investors cannot consistently earn above normal returns based solely on publicly available information, such as earnings, dividend, and sales data.

·  Strong Form: This form states that the financial markets price securities such that, all information (public and non-public) is fully reflected in the securities price; investors should not expect to earn superior returns on a consistent basis, no matter what insight or research they may bring to the table. 

While a rich literature has been established regarding to test whether EMH actually applies in any of its three forms in real world markets – probably the most difficult evidence to overcome for backers of EMH is the existence of a vibrant money management and mutual fund industry charging value-added fees for their services. 

In fact, no less than Warren Buffett has suggested that the markets are decidedly not efficient. 

Assessment

And so, while there has been a growing move towards index funds – as well as ETFs – the strength of the money management industry may reflect investor’s concern with risk management and asset allocation – as much as any view that a manager or individual can “beat the market.”   

Conclusion

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Filed under: Investing, Portfolio Management | Tagged: capital markets, efficient market hypothesis, EMH, Financial Markets, Jeffrey S. Coons, MPT, Napier | 3 Comments »