Efficient Market Hypothesis (EMH): Definition and Critique

What Is the Efficient Market Hypothesis (EMH)?

The efficient market hypothesis (EMH), alternatively known as the efficient market theory, is a hypothesis that states that share prices reflect all available information and consistent alpha generation is impossible.

According to the EMH, stocks always trade at their fair value on exchanges, making it impossible for investors to purchase undervalued stocks or sell stocks for inflated prices. Therefore, it should be impossible to outperform the overall market through expert stock selection or market timing. The only way an investor can obtain higher returns is by purchasing riskier investments.

Understanding the Efficient Market Hypothesis (EMH)

Although it is a cornerstone of modern financial theory, the EMH is highly controversial and often disputed.

Proponents of EMH argue it is pointless to search for undervalued stocks or to try to predict trends in the market through either fundamental or technical analysis. Because stock prices reflect all available information, and because of the randomness of the market, the best investing strategy is a low-cost, passive portfolio.

Theoretically, neither technical nor fundamental analysis can produce risk-adjusted excess returns (alpha) consistently, and only inside information can result in outsized risk-adjusted returns.

While academics point to a large body of evidence in support of EMH, an equal amount of dissension also exists. For example, investors such as Warren Buffett have consistently beaten the market over long periods, which by definition is impossible according to the EMH.

Detractors of the EMH also point to events such as the 1987 stock market crash, when the Dow Jones Industrial Average (DJIA) fell by over 20% in a single day, and asset bubbles as evidence that stock prices can seriously deviate from their fair values.

EMH and Passive Investing

The EMH argues for a passive investing strategy, rather than an active one, in which investors buy and hold a low-cost portfolio over the long term to achieve the best returns.

Data compiled by Morningstar Inc., in its 2024 Active/Passive Barometer study showed that actively managed funds can outperform passive ones: from 2023 to 2024, 51% of active funds outperformed passive funds. Better success rates were found in bond funds, while active foreign equity funds and large-cap funds underperformed passive funds in these categories. However, active funds' long-term performance is still generally below that of passive funds. The 2019 version of the same study found that, from 2009 to 2019, only 23% of active managers were able to outperform their passive peers. In general, investors have fared better by investing in low-cost index funds or ETFs.

While a percentage of active managers do outperform passive funds at some point, the challenge for investors is being able to identify which ones will do so over the long term. As shown in the 2019 report, less than 25% of the top-performing active managers can consistently outperform their passive manager counterparts over time.

Market Inefficiencies

The EMH proposes that markets are efficient. However, there are some markets that are demonstrably less efficient than others.

An inefficient market is one in which an asset's prices do not accurately reflect its true value, which may occur for several reasons. Market inefficiencies may exist due to information asymmetries, a lack of buyers and sellers (i.e. low liquidity), high transaction costs or delays, market psychology, and human emotion, among other reasons. Inefficiencies often lead to deadweight losses. In reality, most markets do display some level of inefficiencies. In extreme cases, an inefficient market can be an example of a market failure.

Accepting the EMH in its purest (strong) form may be difficult as it states that all information in a market, whether public or private, is accounted for in a stock's price. However, modifications of EMH exist to reflect the degree to which it can be applied to markets:

• Semi-strong efficiency: This form of EMH implies all public (but not non-public) information is calculated into a stock's current share price. Neither fundamental nor technical analysis can be used to achieve superior gains.
• Weak efficiency: This type of EMH claims that all past prices of a stock are reflected in today's stock price. Therefore, technical analysis cannot be used to predict and beat the market.

The Bottom Line

The efficient market hypothesis (EMH), also known as the efficient market theory, posits that markets are efficient, meaning share prices reflect all available information, both public and private. This means that stocks trade at their fair value, so most investors will see the best results from holding a low-cost, passive portfolio over the long term.

Opponents of EMH believe that it is possible to beat the market and that stocks can deviate from their fair market values. This has been demonstrated by investors such as Warren Buffet, whose strategy of investing in undervalued stocks has earned billions. Like many economic theories, the EMH cannot fully reflect real-world conditions. However, research has found that its conclusions are generally correct: a low-cost, passive portfolio will, on average, achieve the best long-term results for most investors.