Efficient Market Hypothesis

What is the efficient market hypothesis?

The efficient market hypothesis (EMH) proposes that asset prices incorporate a specified set of available information. The central issue is whether that information can still be used to earn returns beyond the appropriate risk-adjusted benchmark.

The three forms

Fama’s 1970 review distinguishes

• weak-form tests using historical prices,
• semi-strong tests using public information,
• and strong-form tests that include private information.

Each form makes a different claim about what prices reflect.

A public-information example

Suppose a company announces earnings above what investors expected. Under semi-strong efficiency, the new public information is incorporated into the price as it becomes available. A subsequent buyer cannot assume that the good news still offers an extra return simply because it is good: the purchase price may already reflect it. The question is whether trading on that announcement yields returns beyond the appropriate benchmark, after relevant costs—not whether the price rose.

Why testing it is difficult

Someone beating an index does not settle the question. You need to know what information they used, how much risk they took, and which return benchmark is appropriate. Luck matters, too.

Prices can change in an efficient market because news arrives and outcomes differ from expectations. The hypothesis is about how prices incorporate information, not perfect foresight or a promise that no investor will ever outperform.

Criticisms and competing explanations

One challenge is momentum: the tendency, in some samples and time horizons, for recent relative winners to keep outperforming recent losers. Jegadeesh and Titman’s 1993 study reported such a pattern over three- to twelve-month holding periods. Testing its implication for efficiency requires specifying the risk model, accounting for trading costs, and checking whether the pattern survives beyond the data used to find it. A historical return pattern is not a guarantee of a currently profitable trading rule.

Disputes about market anomalies, behavioral finance and price bubbles concern whether prices reflect the relevant information and how expected returns should be measured. A criticism of investor rationality is not by itself a test of how market prices incorporate information.

The three forms also imply different tests of investment analysis. Historical-price strategies address weak-form efficiency; strategies using public reports or news address semi-strong efficiency. Strong-form efficiency extends the claim to private information. Active-management outperformance needs to be assessed against the information set and risk-adjusted benchmark being tested.