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The Weak, Strong, and Semi-Strong Efficient Market Hypotheses

Learn about the three versions of the efficient market hypothesis

J.B. Maverick is an active trader, commodity futures broker, and stock market analyst 17+ years of experience, in addition to 10+ years of experience as a finance writer and book editor.

The efficient market hypothesis (EMH), as a whole, theorizes that the market is generally efficient, but the theory is offered in three different versions: weak, semi-strong, and strong.

The basic efficient market hypothesis posits that the market cannot be beaten because it incorporates all important determining information into current share prices . Therefore, stocks trade at the fairest value, meaning that they can't be purchased undervalued or sold overvalued .

The theory determines that the only opportunity investors have to gain higher returns on their investments is through purely speculative investments that pose a substantial risk.

Key Takeaways

The efficient market hypothesis posits that the market cannot be beaten because it incorporates all important information into current share prices, so stocks trade at the fairest value.
Though the efficient market hypothesis theorizes the market is generally efficient, the theory is offered in three different versions: weak, semi-strong, and strong.
The weak form suggests today’s stock prices reflect all the data of past prices and that no form of technical analysis can aid investors.
The semi-strong form submits that because public information is part of a stock's current price, investors cannot utilize either technical or fundamental analysis, though information not available to the public can help investors.
The strong form version states that all information, public and not public, is completely accounted for in current stock prices, and no type of information can give an investor an advantage on the market.

The three versions of the efficient market hypothesis are varying degrees of the same basic theory. The weak form suggests that today’s stock prices reflect all the data of past prices and that no form of technical analysis can be effectively utilized to aid investors in making trading decisions.

Advocates for the weak form efficiency theory believe that if the fundamental analysis is used, undervalued and overvalued stocks can be determined, and investors can research companies' financial statements to increase their chances of making higher-than-market-average profits.

The semi-strong form efficiency theory follows the belief that because all information that is public is used in the calculation of a stock's current price , investors cannot utilize either technical or fundamental analysis to gain higher returns in the market.

Those who subscribe to this version of the theory believe that only information that is not readily available to the public can help investors boost their returns to a performance level above that of the general market.

The strong form version of the efficient market hypothesis states that all information—both the information available to the public and any information not publicly known—is completely accounted for in current stock prices, and there is no type of information that can give an investor an advantage on the market.

Advocates for this degree of the theory suggest that investors cannot make returns on investments that exceed normal market returns, regardless of information retrieved or research conducted.

There are anomalies that the efficient market theory cannot explain and that may even flatly contradict the theory. For example, the price/earnings (P/E) ratio shows that firms trading at lower P/E multiples are often responsible for generating higher returns.

The neglected firm effect suggests that companies that are not covered extensively by market analysts are sometimes priced incorrectly in relation to their true value and offer investors the opportunity to pick stocks with hidden potential. The January effect shows historical evidence that stock prices—especially smaller cap stocks—tend to experience an upsurge in January.

Though the efficient market hypothesis is an important pillar of modern financial theories and has a large backing, primarily in the academic community, it also has a large number of critics. The theory remains controversial, and investors continue attempting to outperform market averages with their stock selections.

Due to the empirical presence of market anomalies and information asymmetries, many practitioners do not believe that the efficient markets hypothesis holds in reality, except, perhaps, in the weak form.

What Is the Importance of the Efficient Market Hypothesis?

The efficient market hypothesis (EMH) is important because it implies that free markets are able to optimally allocate and distribute goods, services, capital, or labor (depending on what the market is for), without the need for central planning, oversight, or government authority. The EMH suggests that prices reflect all available information and represent an equilibrium between supply (sellers/producers) and demand (buyers/consumers). One important implication is that it is impossible to "beat the market" since there are no abnormal profit opportunities in an efficient market.

What Are the 3 Forms of Market Efficiency?

The EMH has three forms. The strong form assumes that all past and current information in a market, whether public or private, is accounted for in prices. The semi-strong form assumes that only publicly-available information is incorporated into prices, but privately-held information may not be. The weak form concedes that markets tend to be efficient but anomalies can and do occur, which can be exploited (which tends to remove the anomaly, restoring efficiency via arbitrage ). In reality, only the weak form is thought to exist in most markets, if any.

How Would You Know If the Market Is Semi-Strong Form Efficient?

To test the semi-strong version of the EMH, one can see if a stock's price gaps up or down when previously private news is released. For instance, a proposed merger or dismal earnings announcement would be known by insiders but not the public. Therefore, this information is not correctly priced into the shares until it is made available. At that point, the stock may jump or slump, depending on the nature of the news, as investors and traders incorporate this new information.

The efficient market hypothesis exists in degrees, but each degree argues that financial markets are already too efficient for investors to consistently beat them. The idea is that the volume of activity within markets is so high that the value of resulting prices are as fair as can be. The weak form of the theory is the most lenient and concedes that there are circumstance when fundamental analysis can help investors find value. The strong form of the theory is the least lenient in this regard, while the semi-strong form of the theory holds a middle ground between the two.

Burton Gordon Malkiel. "A Random Walk Down Wall Street: The Time-tested Strategy for Successful Investing," W.W Norton & Company, 2007.

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Efficient Market Hypothesis

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The efficient market hypothesis is a theory that market prices fully reflect all available information, i.e. that market assets, like stocks , are worth what their price is. The theory suggests that it's impossible for any individual investor to leverage superior intelligence or information to outperform the market, since markets should react to information and adjust themselves. Any intelligent investor buying a stock is doing so because they believe the stock is worth more than the data (typically historical returns, projected returns, macroeconomic trends , industry trends, etc.) support it being worth. They think that the data is wrong and undervaluing the stock. Economists counter that investors are either buying riskier stocks and undervaluing the risk or succeeding through chance. Put another way, as Burton Malkiel says in his book, A Random Walk Down Wall Street , the efficient market hypothesis means that "a blindfolded chimpanzee throwing darts at the Wall Street Journal could select a portfolio that would do as well as the experts."

As this, essentially, suggests that the tens of thousands of experts who work as active investors are worthless, it has been heavily critiqued. These critiques, themselves, come from successful investors like Warren Buffett who points to the undervaluing of "value stocks" (as opposed to the sexier growth stocks), behavioral economists who point to humanity's inefficiencies, and experts who have used valuations techniques, like dividend yields and price-earnings ratios to generate higher returns.

French mathematician, Louis Bachelier is considered to many to be the first to apply probability theory to markets. [1] Though his work didn't reach a wide audience until the 1950s and 1960s. Eugene Fama is credited, over the course of his career, for much of modern theories of efficient markets, expanding Bachelier's initial work, and starting with Fama's publication, in 1965 of his PhD thesis. Both used mathematical models of random walks and were influenced by Hayek's 1945 argument that markets are the most efficient way to aggregate information.

Weak, Semi-Strong, and Strong Efficiency

Attacks (and responses to attacks) on the efficient market hypothesis, response to attacks on the efficient market hypothesis, how stocks respond to interest rates, investment strategies for proponents of the efficient market hypothesis, possible paradoxes.

Efficient markets are said to exist in varying degrees of efficiency, generally categorized as weak, semi-strong, and strong. These degrees of strength pertain markets responding to information.

In strong efficiency markets, all public and private information is reflected in market prices. This includes insider information (and thus if there are laws prohibiting insider information from being made public, strong efficiency is not in place). In such a market investors, overall, cannot earn excess returns because the market has priced in historical and future (trend) information. Those individual investors are said to consistently outperform the market, maybe doing so simply because any log-normal distribution of thousands of fund managers will include some that consistently outperform the average.

In semi-strong efficiency markets, investors respond very quickly to new information. Because of the speed of information being responded to, investors cannot make excess returns from information. (There are cases where investors set up communications networks to arbitrage information faster than other investors could, but this is a market inefficiency that was corrected for over time). The contention around semi-strong markets is that they have factored in all available information, so fundamental and technical analysis (i.e. doing analysis from available information) does not reveal underpriced securities for investors to make excess returns from.

In weak efficiency markets, there is a chance that investors can make some money in the short term, that markets only reflect all currently available information in the long term. However, markets do, eventually, reflect all available information, and it contends that historical data does not have a relationship with future prices, i.e. Investors cannot use past data to predict future prices and gain excess returns.

There is one anomaly to weak efficiency, one that even Fama has acknowledged, and that has been observed in multiple international markets: the momentum effect. Stocks that have historically gone up in the past 3-12 months, tend to continue to go up. Stocks that have historically gone down in the past 3-12 months, tend to continue to go down.

Behavioral Economics Behavioral economists (and behavioral psychologists) study the cognitive bias that humans have and that lead to irrational decision making. At a high level, these biases could prove that investors are inefficient, both signaling that they aren't going to beat the market (consistent with EMH) and that there are arbitrage opportunities to exploit their inefficiencies (inconsistent with EMH). For instance, people have been shown to employ something called hyperbolic discounting, i.e. given two rewards, humans tend to prefer the reward that comes sooner to the one that comes later. And investment fund managers can suffer from this same bias; in some cases their bonus this year is predicated on their returns this year, not their long-term returns, potentially leading to making okay short-term decisions at the expense of great long-term options. Other economists point to herd mentality , loss aversion , and the sunk cost fallacy for reasons why investors will not outperform the market.

Bubbles Stock market bubbles--like the dot-com bubble of the late 90s, and the housing market bubble of the early 2000s--are acknowledged analomies in the EMH. For a period of time markets (and investors) systematically overestimated a set of assets, until they came crashing down. Economists contend that even rare statistical events are allowed under log-normal distributions. But investors counter that there is an arbitrage opportunity here--that some savvy investors made money by realizing these assets were inflated, and that once the market crashed, the assets were deflated. Economists, in turn, counter back that it's hard or abnormal to realize this in real time, and that few investors arbitraged successfully. For instance, in the case of the dot-com bubble, the available information actually supported some of the prevailing high valuations. With internet usage doubling every few months, one could conceive that this would continue (as it inevitably did with a handful of dot-com era companies--Amazon, Ebay, Yahoo--deservedly achieving the same or higher valuations that they had back in the late 90s).

Successful Investors and Value Investing Some notable investors, Warren Buffett being one, contend that investment techniques, like value investing , have let them outperform the market, even when most other investors do only as well as index funds would. Value investing is a technique, pioneered by Benjamin Graham and David Dodd, in which the investor, generally, buys securities that are underpriced according to some form of analysis (see dividend yields and P/E ratios below).

In a famous 1984 lecture at Columbia Business School, Warren Buffett talked about nine successful investors that are not merely statistically outliers on a log-normal distribution curve of efficient markets, “So these are nine records of 'coin-flippers' from Graham-and-Doddsville. I haven’t selected them with hindsight from among thousands. It’s not like I am reciting to you the names of a bunch of lottery winners...I selected these men years ago based upon their framework for investment decision-making...It’s very important to understand that this group has assumed far less risk than average; note their record in years when the general market was weak. While they differ greatly in style, these investors are, mentally, always buying the business, not buying the stock. A few of them sometimes buy whole businesses. Far more often they simply buy small pieces of businesses. Their attitude, whether buying all or a tiny piece of a business, is the same. Some of them hold portfolios with dozens of stocks; others concentrate on a handful. But all exploit the difference between the market price of a business and its intrinsic value.”

These, and other value investors, look at fundamental analysis like the following to determine predictable patters: Bar graph of 10-year stock returns grouped by dividend yields [2]

Have high dividend yields : Dividends are cash returns that companies choose to pass on to their shareholders. For instance a company might return $100 million to it's shareholders by giving $1 for each of the 1 million shares outstanding. The chart to the right takes the dividend yield of the S&P 500 each quarter from 1926 - 1990 and then finds the ten-year return (through 2000). It shows that investors have earned a greater rate of return from high-dividend yielding stocks. However, as Malkiel notes: "These findings are not necessarily inconsistent with efficiency. Dividend yields of stocks tend to be high when interest rates are high, and they tend to be low when interest rates are low (see below ). Consequently, the ability of initial yields to predict returns may simply reflect the adjustment of the stock market to general economic conditions. Moreover, the use of dividend yields to predict future returns has been ineffective since the mid-1980s. Dividend yields have been at the three percent level or below continuously since the mid-1980s, indicating very low forecasted returns." [2] This low-dividend trend has continued through the 21st century, with many companies electing for share repurchases as a theoretically "better way" to return capital to investors. Bar graph of 10-year stock returns grouped by P/E ratios [2]

Have low price-to-earning multiples or have low price-to-book ratios (P/E ratios): Another favored metric of value investors is the Price to earnings ratio. Some companies, like Facebook, have relatively high multiples of earnings, as of December 1st 2016, it was $\approx 44$ meaning that the total return Facebook earned for the previous four quarters was $\frac{1}{44}$th of the stock price. Or, put another way, it would take 44 years, at the current rate of net earnings for Facebook to pay an investor back for their purchase price. The key here being that investors who are choosing to buy Facebook believe those earnings will increase. However the size of this P/E ratio would, traditionally, make it not a good candidate for value investors. In the chart to the right, S&P 500 stocks are grouped by their quarterly P/E ratios from 1926 - 1990 and then the average of their ten-year return (through 2000) is calculated. Stocks with P/E ratios under 9.9 outperformed others in this study, and are generally considered "value stocks" or stocks bought "at a discount". The famous saying for value investors is "buy low, sell high" or buy when the stock is undervalued, sell when it's at par or overvalued. Where the advocate of the efficient market hypothesis would respond that the market prices in all information stocks will only be temporarily under or over valued.

The primary evidence for the efficient market hypothesis is the preponderance of studies showing that active investors do not outperform the market. There is a substantial body of work showing that mutual fund managers do not outperform the market [3] [4] [5] [6] . This is even true for investors that have performed well in the past. Like stocks, past performance is not an indicator of future success. And many have concluded that the fees that investment advisors charge cause their customers to underperform the market overall.

A number of studies have specifically looked at how the market responses to new information , theorizing that if it is an efficient market individual announcements should not, on average, raise the price of stocks because this information would already be priced in. [7] [8]

Fama's response to significant anomalies , where the market over or under reacts, is that "an efficient market generates categories of events that individually suggest that prices over-react to information. But in an efficient market, apparent underreaction will be about as frequent as overreaction. If anomalies split randomly between underreaction and overreaction, they are consistent with market efficiency." "The important point is that the literature does not lean cleanly toward either [over or under reaction] as the behavioral alternative to market efficiency. "

Stocks are highly sensitive to interest rates. If low-risk government bonds general significantly high levels of interest, investors will prefer them to their risky stock alternatives. As such, stock prices can go up or down based on interest rate prices (again the market should price in expectations about whether interest rates will change). As an example, suppose that stocks are priced as the present value of the expected future stream of dividends: \[r = \frac{D}{P} + g\] Where $r$ is the rate of return, $D$ is the dividend yield, $P$ is the price, and $g$ is the growth rate.

Suppose the "riskless rate" on government securities is 4%, and the risk premium on equity investments is 2%. Also suppose that there is a stock that is expected to have a growth rate of 2% and a dividend of $2 per share, what should the equity be priced at? This expected rate of return, if the interest rate is 4% and the risk premium is 2%, would be 6%. And formula is as follows: $r = \frac{D}{P} + g$ $0.06 = $2.00/P + 0.02$ $0.04 = $2.00/P$ $P = $2.00/0.04 = $50.00$ The equity should be priced at $50.

In the example on the efficient market hypothesis wiki, we said that in a market where the "riskless rate" is 4%, the risk premium is 2%, the dividend yield is $2, and the expected growth rate is 2% then the stock, priced only as the present value of the expected value of the stream of future dividends, should be worth $50.00. This follows from the formula: \[r= \frac{D}{P} + g\] What happens when the interest rate rises to 5%? How much should the stock price increase or decrease if nothing else changes?

The principal suggestion from Efficient Market Hypothesis Advocates is to minimize costs (both fees and taxes if possible). Warren Buffett himself has agreed that most investors do not outperform the market, saying in his 2013 letter [9] that after his passing, his money will be invested for his family in the following way: "10% of the cash in short-term government bonds and 90% in a very low-cost S&P 500 index fund. (I suggest Vanguard’s.) I believe the trust’s long-term results from this policy will be superior to those attained by most investors--whether pension funds, institutions or individuals--who employ high-fee managers."

In general, large institutions (pension funds, endowments, foundations, etc.) have followed this advice and have been shifting from actively managed funds to passively managed ones . According to Morningstar's 2015 Annual report, " In 2015, actively managed mutual funds suffered more than $200 billion of net outflows, compared with net inflows of more than $400 billion for passively managed funds." [10]

In private, some active investors gleefully appreciate the spread of the Efficient Market Hypothesis and the shift to passively managed funds. Because the fewer people actively managing funds means fewer people to compete with. They would argue that active managers play a role in ensuring market efficiency and with fewer active managers the market will become less efficient, presenting the few that are left with more opportunities. I.E. that as more people believe in the efficient market hypothesis and passively manage their funds in indexes, the markets will become less efficient and open up opportunities for active money managers.

Overall, some consider the whole theory something of a paradox. Statistically it seems valid, but there are numerous anomalies and numerous investors with long term periods of success (for instance Berkshire Hathaway's 51 year compound annual return is 19-20% a year versus the S&P's 9.7%). There is compelling evidence on both sides, but one of the greatest advantages the theory has propelled is to point out investors' historical overreliance on investment professionals and the massive industry predicated on this need.

Bachelier, L. The Theory of Speculation . Retrieved December 1st 2016, from http://press.princeton.edu/chapters/s8275.pdf
Malkiel, B. The Efficient Market Hypothesis and Its Critics . Retrieved December 1st 2016, from http://www.princeton.edu/ceps/workingpapers/91malkiel.pdf
Jensen, M. The Performance of Mutual Funds in the Period 1945-1964 . Retrieved November 23rd 2016, from http://www.e-m-h.org/Jens68.pdf
Fama, E. Efficient Capital Markets: A Review of Theory and Empirical Work . Retrieved November 23rd, 2016, from http://www.jstor.org/stable/2325486
Fama, E. Efficient Capital Markets: II . Retrieved November 23rd 2016, from http://faculty.chicagobooth.edu/jeffrey.russell/teaching/Finecon/readings/fama.pdf
Sommer, J. Who Routinely Trounces the Stock Market? Try 2 Out of 2,862 Funds . Retrieved November 23rd 2016, from http://www.nytimes.com/2014/07/20/your-money/who-routinely-trounces-the-stock-market-try-2-out-of-2862-funds.html
Ball, R., & Brown, P. An Empirical Evaluation of Accounting Income Numbers . Retrieved December 1st 2016, from http://www.drthomaswu.com/uicfat/1.pdf
Fama, E., Fisher, L., Jensen, M., & Roll, R. The Adjustment of Stock Prices to New Information . Retrieved December 1st 2016, from https://www.jstor.org/stable/2525569?seq=1#page_scan_tab_contents
Hathaway, B. Berkshire Hathaway . Retrieved November 29th 2016, from http://www.berkshirehathaway.com/letters/2013ltr.pdf
Morningstar, . 2015 Annual Report . Retrieved December 1st 2106, from https://corporate.morningstar.com/us/documents/PR/Morningstar-Annual-Report-2015.pdf

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The New Palgrave Dictionary of Economics pp 1–7 Cite as

Efficient Market Hypothesis

Burton G. Malkiel 2
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A capital market is said to be efficient if it fully and correctly reflects all relevant information in determining security prices. Formally, the market is said to be efficient with respect to some information set, ϕ, if security prices would be unaffected by revealing that information to all participants. Moreover, efficiency with respect to an information set, ϕ, implies that it is impossible to make economic profits by trading on the basis of ϕ.

This chapter was originally published in The New Palgrave: A Dictionary of Economics , 1st edition, 1987. Edited by John Eatwell, Murray Milgate and Peter Newman

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Malkiel, B.G. (1987). Efficient Market Hypothesis. In: The New Palgrave Dictionary of Economics. Palgrave Macmillan, London. https://doi.org/10.1057/978-1-349-95121-5_42-1

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BUS614: International Finance

Market Efficiency

There are generally two theories to assist pricing. The Efficient Market Hypothesis (EFM) and the Behavioural Finance Theory. Understanding the limitations of each of the theories is critical. Read the three concepts on this page to have a comprehensive understanding of EFM. What are the limitations of the EMH?

Implications and Limitations of the Efficient Market Hypothesis

Weak, semi-strong, and strong.

The efficient-market hypothesis emerged as a prominent theory in the mid-1960's. Paul Samuelson had begun to circulate Bachelier's work among economists. In 1964 Bachelier's dissertation along with the empirical studies mentioned above were published in an anthology edited by Paul Cootner. In 1965 Eugene Fama published his dissertation arguing for the random walk hypothesis, and Samuelson published a proof for a version of the efficient-market hypothesis. In 1970 Fama published a review of both the theory and the evidence for the hypothesis. The paper extended and refined the theory, included the definitions for three forms of financial market efficiency: weak, semi-strong, and strong.

It has been argued that the stock market is "micro efficient," but not "macro inefficient. " The main proponent of this view was Samuelson, who asserted that the EMH is much better suited for individual stocks than it is for the aggregate stock market. Research based on regression and scatter diagrams has strongly supported Samuelson's dictum.

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Efficient Market Hypothesis

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The efficient market hypothesis is an economic theory which stipulates that the prices of traded assets, like stocks, reflect all the publicly available information of the market. 1 This means that if you are investing in assets based on public information, it is impossible to outperform the market over time, because buyers and sellers are working with this same information. 2 The efficient market hypothesis is part of liberal economic thought, as it follows neoliberal thought of the efficient free-market that does not require any intervention.

In order to better understand the efficient market hypothesis, it is first important to understand basic stock investing. At its simplest level, stock prices will change based on positive or negative information about the corporation to which they belong. This is because if an investor hears good news about a corporation, they will likely go buy stocks of this corporation, thus driving up the stock price. If an investor hears bad news about a corporation, they might sell their stocks, therefore lowering the stock price.

The efficient market hypothesis suggests that there is a direct relationship between news (or information) and prices, as buyers and sellers generally have access to the same information. If prices move according to public information, they occur efficiently (in a timely manner), which means that stocks are trading at their ‘fair’ price. 3

Information cannot be predicted by the general public, as proponents of the hypothesis say that the market is random. Therefore, it follows that investors cannot ‘beat’ the market by buying undervalued stocks or selling inflated prices. Although you might get lucky once or twice, the efficient market hypothesis suggests that you cannot consistently outperform the market average when it comes to investment returns. 3 Investors therefore have to make decisions through speculation, which has great risks. 4

For example, you might now be sitting at home thinking that you should have invested in Zoom, whose stock prices increased by more than 100% since COVID-19 began. 5 However, before the pandemic, these stocks weren’t ‘undervalued’, because no one could have predicted a global shutdown that forced millions to work from home. According to the efficient market hypothesis, based on publicly available information, it would have been impossible for you to realize that Zoom stocks would increase in price until they already had, at which point you wouldn’t make as much by buying stocks at the new inflated price.

I’d compare stock pickers to astrologers but I don’t want to bad mouth astrologers. – Eugene Fama, the ‘father’ of modern finance 1

Fundamental Analysis: a trader analysis strategy that tries to predict price movements in the stock market by gauging if a stock is undervalued or overvalued by examining factors like the state of the economy, industry conditions, or even the effectiveness of a company’s management. 6

Technical Analysis: a trader analysis strategy that examines past price movements in order to predict future price movements in the stock market. 7

Random walk theory: a theory that suggests that changes in stock prices are completely independent of other stock price changes, which means that trends in a market cannot be used for prediction. 8

Economic/Asset Bubble: a surge in asset prices (driven by exhilarated market behavior) which causes the stock price of an asset to greatly exceed its fair market value. Usually, the rapid escalation of market value is followed by a ‘crash’, where the bubble bursts and assets quickly decrease in value. 9

People who partake in stock investment are usually motivated by a goal of making money based on the existence and identification of undervalued and overvalued shares. Investors are always trying to ‘beat the market’ – but the efficient market hypothesis challenges the idea that this is ever possible.

Way back in the early 1900s, French mathematician Louis Bachelier performed a stock-market analysis that demonstrated the randomness of the market: today’s returns had no impact on tomorrow’s stocks. 10 Although the efficient market hypothesis didn’t come to fruition until 1970, work conducted by people like Bachelier set the groundwork for the hypothesis. By showing that the stock market operated partially according to random action, Bachelier suggested that it would be impossible to predict the movement of stock prices, an important step towards the efficient market hypothesis. 10

In 1965, Eugene Fama, who has been a key player in the development of modern finance, used Bachelier’s random walk model to show that the techniques used by technical analysts to predict stock returns had no power. 10 At first, the emphasis on the randomness of the market led many economists to abandon the economic meaning of stock returns. However, in the mid-1960s, this view began to change as economists demonstrated that randomness in returns was to be expected from an efficient stock market. Essentially, they suggested that the only thing that could be predicted is the fact that stock market turns would be unpredictable.

Eugene Fama formalized his ideas in his now-famous paper, “Efficient Capital Markets: A Review of Theory and Empirical Work.” In this 1970 paper, he divided the efficient market theory into three hypotheses: the weak form, the semi-strong form, and the strong form.

The weak form states that today’s market price reflects all past data and therefore no form of technical analysis will help investors make predictions, although fundamental analysis can still help. The semi-strong form states that because all publicly available information is part of a stock’s current price, only insider information can help investors, rather than technical or fundamental analysis. The strong form states that both publicly available and non-publicly available information is already reflected within a stock price, so there is no additional information that can help people ‘beat the market’. 4

In the 1970s, the semi-strong form of the efficient market hypothesis was most widely accepted. However, in the 1980s, a number of inconsistencies put the belief under question. 10

Consequences

Financial economic theories have large implications for society; often, different theories benefit and cost different groups. The efficient market hypothesis has important political implications by adhering to liberal economic thought.

The efficient market hypothesis suggests that there need not be any governmental intervention within the market because stock prices are always being traded at a ‘fair’ market value. The efficient market hypothesis was used as evidence by researchers at Michigan Business & Entrepreneurial Law to push the notion of deregulation of the financial sector. Deregulation proposes that state regulations should be lifted because the market is self-regulating and self-correcting. 11 If the market is efficient by itself, then government intervention and regulation might actually be harmful and stifle competition.

The efficient market hypothesis also has implications for the field of behavioral economics. The hypothesis suggests that investors are rational people who buy and sell stocks based on available information. It therefore gives credence to traditional economic theory instead of behavioral economics, as the former believes in homo economicus , the perfectly rational being, while the latter believes that people are often influenced by ‘irrational’ factors like emotions, beliefs and cultural influences in their financial decisions. Of course, only a certain amount of information is available to any one person at any given time, and therefore decisions are bound by limitations ( bounded rationality ).

Most directly, however, the efficient market hypothesis has consequences for investors and analysts. By suggesting that predictions on stock returns are based on nothing more than speculation, the hypothesis leaves little room for fundamental or technical analysis. The efficient market hypothesis opposes technical trading strategies and instead suggests that people should invest their money in lower risk markets, like low-cost portfolios. 12

Controversies

Before the efficient market hypothesis emerged in the 1970s, the reigning economic theory on the financial market was that speculation impacted the price of stocks. This belief was perpetuated by John Maynard Keynes in 1936, who suggested that because investors make decisions based on what they think other investors are going to do, stock prices are more closely aligned to speculation than economic fundamentals. 10 Today, many people still believe that people’s opinions on the market- for example, how optimistic or pessimistic they feel about the world – can drive excessively high or excessively low stock prices. Stocks, therefore, are not always traded at a fair market price. 3

If people make investing decisions based on their predictions of others’ behavior, or based on optimistic and pessimistic moods, then people are not purely rational investors. Behavioral economists, who know that people are often irrational, therefore argue against the efficient market hypothesis. Economist Richard Thaler , for example, conducted a study showing that markets tend to ‘overreact’ following trends: When a stock performed well over a 3-5 year period they often reverted their means over the next 3-5 years. Such extreme swings away from economic foundations suggests that stock prices are not always equated to a ‘fair market value’. 10

Other principles, like the neglected firm effect, also provide evidence against the efficient market hypothesis. The neglected firm effect stipulates that because the stocks of lesser-known companies are left out of market analysis, savvy investors can buy their undervalued stocks, which means that the lesser-known companies often end up outperforming better known companies. 13

The fact that people do actually often make millions from trading in the stock market also calls the efficient market hypothesis into question. For example, Warren Buffett , John Templeton, Peter Lynch and Paul Tudor Jones are all investors who consistently generate great returns that go beyond the performance of the overall market. 3 If the efficient market hypothesis suggests all people have an equal opportunity to make money since prices react to public information, then people would certainly not be able to make so much more than others from investing.

To discuss controversies surrounding the efficient market hypothesis, it is important to discuss the 2008 financial crisis. Some people believe that the financial crisis could have been predicted, but that proponents of the efficient market hypothesis failed to see the bubble in asset prices, and that if they did not blindly follow the hypothesis, they may have been able to give people due warning. 14 However, others suggest that it is because not enough people believed in the efficient market hypothesis that the crisis occurred. Proponents of this argument say that because people thought it was easy to beat the market, there was a large amount of investment in short-term trends. Investors had to borrow heavily in order to invest in these short-term trends, which led to banks having heavy debt burdens that contributed to the economic crisis. 14

The 2008 financial crisis also brought under question whether deregulation of the financial sector was in fact beneficial. According to the efficient market hypothesis, the government should not have intervened following the crash, as stocks would eventually have levelled back out by themselves thanks to an efficient market. The government did intervene, however, which means we will never really know if the market could have survived without intervention.

COVID-19 and the Financial Market

According to the efficient market hypothesis, prices in the market will quickly adapt to public information and perception. However, American economist Robert Shiller disputes this view in light of the recent global pandemic. The S&P 500 index, which measures the stock performance of 500 large companies, showed an all-time record high on February 19th, 2020, as the virus began to spread across the globe. 15 This trend suggests that the U.S market was not rationally responding to publicly available information, as people were investing more than ever even as they were seeing cities shut down and people forced to cease working, which should have indicated that they should hold onto their money to prepare for what might be coming their way. This data suggests that the financial market is more irrational than the efficient market hypothesis suggests.

However, alternatively, COVID-19 demonstrates just how unpredictable the market is: who could have presumed what kind of stocks would shoot up in price, and what kind would crash, if we could not predict the state of the world? Neither fundamental nor technical analysis would have proven to be useful trading strategies during these unprecedented times.

Related TDL Resources

What Can George Costanza Teach Us About Making Better Investment Choices?

Investing is incredibly difficult. According to our writer Shayan Gose, one of the biggest mistakes people make while investing is the disposition effect : selling assets that have increased in value and keeping assets that have decreased in value because we are driven by pride, rather than profit. The disposition effect doesn’t make sense for a financial market that adheres to the efficient market hypothesis and homo economicus, leading Gose to lend advice on how to avoid the disposition effect and stick to rational investment decisions.

Phantasy: The Unconscious Process Behind Financial Instability

This article takes the opposing view from the efficient market hypothesis. TDL’s editor Nathan Collett interviews business administration researcher Selim Aren, who suggests that unconscious drivers are often the force behind the fluctuations in today’s financial market. Similarly to Keynes, Aren suggests that speculation and herd behavior influence stock prices therefore stock prices often do not reflect fair market value.

Warren Buffett: Your $85 Billion Average Joe

A proponent of ‘value investing,’ Warren Buffett has made billions of dollars off the stock market by choosing his investments wisely and sticking with them for decades. Unlike many other investors, Buffett is not eager to trade, and is instead willing to see his investments through until they provide returns, rather than rushing to sell them.

Ting So, S. (2019, July 19). The very annoying efficient market hypothesis and how to beat it . Medium. https://medium.com/endowus-insights/the-very-annoying-efficient-market-hypothesis-and-how-to-beat-it-21794a73754a
Marginal Revolution University. (2018, April 7). What Is the Efficient Market Hypothesis? [Video]. YouTube. https://www.youtube.com/watch?v=AEv9AszJ4_U
Corporate Finance Institute. (2019, July 24). Efficient markets hypothesis – Understanding and testing EMH . https://corporatefinanceinstitute.com/resources/knowledge/trading-investing/efficient-markets-hypothesis/
Maverick, J. B. (2020, September 30). The weak, strong, and semi-strong efficient market hypotheses . Investopedia. https://www.investopedia.com/ask/answers/032615/what-are-differences-between-weak-strong-and-semistrong-versions-efficient-market-hypothesis.asp
Reinicke, C. (2020, March 23). Zoom video has seen its stock spike more than 100% since January as coronavirus pushes millions to work from home (ZM) . Business Insider. https://markets.businessinsider.com/news/stocks/zoom-stock-price-surged-coronavirus-pandemic-video-work-from-home-2020-3-1029023594
Segal, T. (2020, May 14). Fundamental Analysis . Investopedia. https://www.investopedia.com/terms/f/fundamentalanalysis.asp
Chen, J. (2020, May 17). Guide to Technical Analysis . Investopedia. https://www.investopedia.com/terms/t/technical-analysis-of-stocks-and-trends.asp
Smith, T. (2019, June 25). Random Walk Theory . Investopedia. https://www.investopedia.com/terms/r/randomwalktheory.asp
Kenton, W. (2020, August 18). Bubble . Investopedia. https://www.investopedia.com/terms/b/bubble.asp
Jones, S. L., & Netter, J. M. (n.d.). Efficient Capital Markets . The Library of Economics and Liberty. https://www.econlib.org/library/Enc/EfficientCapitalMarkets.html
Kako, P. (2017, August 17). Law and Economics of Financial Deregulation . Michigan Business & Entrepreneurial Law Review. https://mbelr.org/law-and-economics-of-financial-deregulation/
Downey, L. (2020, October 30). Efficient Market Hypothesis (EMH) . Investopedia. https://www.investopedia.com/terms/e/efficientmarkethypothesis.asp
Hayes, A. (2020, September 29). Neglected Firm Effect . Investopedia. https://www.investopedia.com/terms/n/neglectedfirm.asp
Ribstein, L. (2009, December 11). Sorry, Folks: The Efficient Market Hypothesis Did Not Cause The Financial Crisis . Business Insider. https://www.businessinsider.com/sorry-folks-the-efficient-market-hypothesis-did-not-cause-the-financial-crisis-2009-12
Carlson, B. (2020, May 11). Does COVID-19 prove the stock market is inefficient? A Wealth of Common Sense. https://awealthofcommonsense.com/2020/05/does-covid-19-prove-the-stock-market-is-inefficient/

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Efficient Markets Hypothesis (EMH)

EMH Definition and Forms

What Is Efficient Market Hypothesis?

What are the types of emh, emh and investing strategies, the bottom line, frequently asked questions (faqs).

The Efficient Market Hypothesis (EMH) is one of the main reasons some investors may choose a passive investing strategy. It helps to explain the valid rationale of buying these passive mutual funds and exchange-traded funds (ETFs).

The Efficient Market Hypothesis (EMH) essentially says that all known information about investment securities, such as stocks, is already factored into the prices of those securities. If that is true, no amount of analysis can give you an edge over "the market."

EMH does not require that investors be rational; it says that individual investors will act randomly. But as a whole, the market is always "right." In simple terms, "efficient" implies "normal."

For example, an unusual reaction to unusual information is normal. If a crowd suddenly starts running in one direction, it's normal for you to run that way as well, even if there isn't a rational reason for doing so.

There are three forms of EMH: weak, semi-strong, and strong. Here's what each says about the market.

Weak Form EMH: Weak form EMH suggests that all past information is priced into securities. Fundamental analysis of securities can provide you with information to produce returns above market averages in the short term. But no "patterns" exist. Therefore, fundamental analysis does not provide a long-term advantage, and technical analysis will not work.
Semi-Strong Form EMH: Semi-strong form EMH implies that neither fundamental analysis nor technical analysis can provide you with an advantage. It also suggests that new information is instantly priced into securities.
Strong Form EMH: Strong form EMH says that all information, both public and private, is priced into stocks; therefore, no investor can gain advantage over the market as a whole. Strong form EMH does not say it's impossible to get an abnormally high return. That's because there are always outliers included in the averages.

EMH does not say that you can never outperform the market . It says that there are outliers who can beat the market averages. But there are also outliers who lose big to the market. The majority is closer to the median. Those who "win" are lucky; those who "lose" are unlucky.

Proponents of EMH, even in its weak form, often invest in index funds or certain ETFs. That is because those funds are passively managed and simply attempt to match, not beat, overall market returns.

Index investors might say they are going along with this common saying: "If you can't beat 'em, join 'em." Instead of trying to beat the market, they will buy an index fund that invests in the same securities as the benchmark index.

Some investors will still try to beat the market, believing that the movement of stock prices can be predicted, at least to some degree. For that reason, EMH does not align with a day trading strategy. Traders study short-term trends and patterns. Then, they attempt to figure out when to buy and sell based on these patterns. Day traders would reject the strong form of EMH.

For more on EMH, including arguments against it, check out the EMH paper from economist Burton G. Malkiel. Malkiel is also the author of the investing book "A Random Walk Down Main Street." The random walk theory says that movements in stock prices are random.

If you believe that you can't predict the stock market, you would most often support the EMH. But a short-term trader might reject the ideas put forth by EMH, because they believe that they are able to predict changes in stock prices.

For most investors, a passive, buy-and-hold , long-term strategy is useful. Capital markets are mostly unpredictable with random up and down movements in price.

When did the Efficient Market Hypothesis first emerge?

At the core of EMH is the theory that, in general, even professional traders are unable to beat the market in the long term with fundamental or technical analysis . That idea has roots in the 19th century and the "random walk" stock theory. EMH as a specific title is sometimes attributed to Eugene Fama's 1970 paper "Efficient Capital Markets: A Review of Theory and Empirical Work."

How is the Efficient Market Hypothesis used in the real world?

Investors who utilize EMH in their real-world portfolios are likely to make fewer decisions than investors who use fundamental or technical analysis. They are more likely to simply invest in broad market products, such as S&P 500 and total market funds.

Corporate Finance Institute. " Efficient Markets Hypothesis ."

IG.com. " Random Walk Theory Definition ."

Efficient Market Hypothesis (EMH)

Written by True Tamplin, BSc, CEPF®

Reviewed by subject matter experts.

Updated on July 12, 2023

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Table of contents, efficient market hypothesis (emh) overview.

The Efficient Market Hypothesis (EMH) is a theory that suggests financial markets are efficient and incorporate all available information into asset prices.

According to the EMH, it is impossible to consistently outperform the market by employing strategies such as technical analysis or fundamental analysis.

The hypothesis argues that since all relevant information is already reflected in stock prices, it is not possible to gain an advantage and generate abnormal returns through stock picking or market timing.

The EMH comes in three forms: weak, semi-strong, and strong, each representing different levels of market efficiency.

While the EMH has faced criticisms and challenges, it remains a prominent theory in finance that has significant implications for investors and market participants.

Types of Efficient Market Hypothesis

The Efficient Market Hypothesis can be categorized into the following:

Weak Form EMH

The weak form of EMH posits that all past market prices and data are fully reflected in current stock prices.

Therefore, technical analysis methods, which rely on historical data, are deemed useless as they cannot provide investors with a competitive edge. However, this form doesn't deny the potential value of fundamental analysis.

Semi-strong Form EMH

The semi-strong form of EMH extends beyond historical prices and suggests that all publicly available information is instantly priced into the market.

This includes financial statements, news releases, economic indicators, and other public disclosures. Therefore, neither technical analysis nor fundamental analysis can yield superior returns consistently.

Strong Form EMH

The most extreme version of EMH, the strong form, asserts that all information, both public and private, is fully reflected in stock prices.

Even insiders with privileged information cannot consistently achieve higher-than-average market returns. This form, however, is widely criticized as it conflicts with securities regulations that prohibit insider trading .

Assumptions of the Efficient Market Hypothesis

Three fundamental assumptions underpin the Efficient Market Hypothesis.

All Investors Have Access to All Publicly Available Information

This assumption holds that the dissemination of information is perfect and instantaneous. All market participants receive all relevant news and data about a security or market simultaneously, and no investor has privileged access to information.

All Investors Have a Rational Expectation

In EMH, it is assumed that investors collectively have a rational expectation about future market movements. This means that they will act in a way that maximizes their profits based on available information, and their collective actions will cause securities' prices to adjust appropriately.

Investors React Instantly to New Information

In an efficient market, investors instantaneously incorporate new information into their investment decisions. This immediate response to news and data leads to swift adjustments in securities' prices, rendering it impossible to "beat the market."

Implications of the Efficient Market Hypothesis

The EMH has several implications across different areas of finance.

Implications for Individual Investors

For individual investors, EMH suggests that "beating the market" consistently is virtually impossible. Instead, investors are advised to invest in a well-diversified portfolio that mirrors the market, such as index funds.

Implications for Portfolio Managers

For portfolio managers , EMH implies that active management strategies are unlikely to outperform passive strategies consistently. It discourages the pursuit of " undervalued " stocks or timing the market.

Implications for Corporate Finance

In corporate finance, EMH implies that a company's stock is always fairly priced, meaning it should be indifferent between issuing debt and equity . It also suggests that stock splits , dividends , and other financial decisions have no impact on a company's value.

Implications for Government Regulation

For regulators , EMH supports policies that promote transparency and information dissemination. It also justifies the prohibition of insider trading.

Implications of the Efficient Market Hypothesis

Criticisms and Controversies Surrounding the Efficient Market Hypothesis

Despite its widespread acceptance, the EMH has attracted significant criticism and controversy.

Behavioral Finance and the Challenge to EMH

Behavioral finance argues against the notion of investor rationality assumed by EMH. It suggests that cognitive biases often lead to irrational decisions, resulting in mispriced securities.

Examples include overconfidence, anchoring, loss aversion, and herd mentality, all of which can lead to market anomalies.

Market Anomalies and Inefficiencies

EMH struggles to explain various market anomalies and inefficiencies. For instance, the "January effect," where stocks tend to perform better in January, contradicts the EMH.

Similarly, the "momentum effect" suggests that stocks that have performed well recently tend to continue performing well, which also challenges EMH.

Financial Crises and the Question of Market Efficiency

The Global Financial Crisis of 2008 raised serious questions about market efficiency. The catastrophic market failure suggested that markets might not always price securities accurately, casting doubt on the validity of EMH.

Empirical Evidence of the Efficient Market Hypothesis

Empirical evidence on the EMH is mixed, with some studies supporting the hypothesis and others refuting it.

Evidence Supporting EMH

Several studies have found that professional fund managers, on average, do not outperform the market after accounting for fees and expenses.

This finding supports the semi-strong form of EMH. Similarly, numerous studies have shown that stock prices tend to follow a random walk, supporting the weak form of EMH.

Evidence Against EMH

Conversely, other studies have documented persistent market anomalies that contradict EMH.

The previously mentioned January and momentum effects are examples of such anomalies. Moreover, the occurrence of financial bubbles and crashes provides strong evidence against the strong form of EMH.

Efficient Market Hypothesis in Modern Finance

Despite criticisms, the EMH continues to shape modern finance in profound ways.

EMH and the Rise of Passive Investing

The EMH has been a driving force behind the rise of passive investing. If markets are efficient and all information is already priced into securities, then active management cannot consistently outperform the market.

As a result, many investors have turned to passive strategies, such as index funds and ETFs .

Impact of Technology on Market Efficiency

Advances in technology have significantly improved the speed and efficiency of information dissemination, arguably making markets more efficient. High-frequency trading and algorithmic trading are now commonplace, further reducing the possibility of beating the market.

Future of EMH in Light of Evolving Financial Markets

While the debate over market efficiency continues, the growing influence of machine learning and artificial intelligence in finance could further challenge the EMH.

These technologies have the potential to identify and exploit subtle patterns and relationships that human investors might miss, potentially leading to market inefficiencies.

The Efficient Market Hypothesis is a crucial financial theory positing that all available information is reflected in market prices, making it impossible to consistently outperform the market. It manifests in three forms, each with distinct implications.

The weak form asserts that all historical market information is accounted for in current prices, suggesting technical analysis is futile.

The semi-strong form extends this to all publicly available information, rendering both technical and fundamental analysis ineffective.

The strongest form includes even insider information, making all efforts to beat the market futile. EMH's implications are profound, affecting individual investors, portfolio managers, corporate finance decisions, and government regulations.

Despite criticisms and evidence of market inefficiencies, EMH remains a cornerstone of modern finance, shaping investment strategies and financial policies.

Efficient Market Hypothesis (EMH) FAQs

What is the efficient market hypothesis (emh), and why is it important.

The Efficient Market Hypothesis (EMH) is a theory suggesting that financial markets are perfectly efficient, meaning that all securities are fairly priced as their prices reflect all available public information. It's important because it forms the basis for many investment strategies and regulatory policies.

What are the three forms of the Efficient Market Hypothesis (EMH)?

The three forms of the EMH are the weak form, semi-strong form, and strong form. The weak form suggests that all past market prices are reflected in current prices. The semi-strong form posits that all publicly available information is instantly priced into the market. The strong form asserts that all information, both public and private, is fully reflected in stock prices.

How does the Efficient Market Hypothesis (EMH) impact individual investors and portfolio managers?

According to the EMH, consistently outperforming the market is virtually impossible because all available information is already factored into the prices of securities. Therefore, it suggests that individual investors and portfolio managers should focus on creating well-diversified portfolios that mirror the market rather than trying to beat the market.

What are some criticisms of the Efficient Market Hypothesis (EMH)?

Criticisms of the EMH often come from behavioral finance, which argues that cognitive biases can lead investors to make irrational decisions, resulting in mispriced securities. Additionally, the EMH has difficulty explaining certain market anomalies, such as the "January effect" or the "momentum effect." The occurrence of financial crises also raises questions about the validity of EMH.

How does the Efficient Market Hypothesis (EMH) influence modern finance and its future?

Despite criticisms, the EMH has profoundly shaped modern finance. It has driven the rise of passive investing and influenced the development of many financial regulations. With advances in technology, the speed and efficiency of information dissemination have increased, arguably making markets more efficient. Looking forward, the growing influence of artificial intelligence and machine learning could further challenge the EMH.

About the Author

True Tamplin, BSc, CEPF®

True Tamplin is a published author, public speaker, CEO of UpDigital, and founder of Finance Strategists.

True is a Certified Educator in Personal Finance (CEPF®), author of The Handy Financial Ratios Guide , a member of the Society for Advancing Business Editing and Writing, contributes to his financial education site, Finance Strategists, and has spoken to various financial communities such as the CFA Institute, as well as university students like his Alma mater, Biola University , where he received a bachelor of science in business and data analytics.

To learn more about True, visit his personal website or view his author profiles on Amazon , Nasdaq and Forbes .

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What is Efficient Market Hypothesis? | EMH Theory Explained

The efficient market hypothesis (EMH) can help explain why many investors opt for passive investing strategies, such as buying index funds or exchange-traded funds ( ETFs ), which generate consistent returns over an extended period. However, the EMH theory remains controversial and has found as many opponents as proponents. This guide will explain the efficient market hypothesis, how it works, and why it is so contradictory.

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What is the efficient market hypothesis?

The efficient market hypothesis (EMH) claims that all assets are always fairly and accurately priced and trade at their fair market value on exchanges. If this theory is true, nothing can give you an edge to outperform the market using different investing strategies and make excess profits compared to those who follow market indexes.

Efficient market definition

An efficient market is where all asset prices listed on exchanges fully reflect their true and only value, thus making it impossible for investors to “beat the market” and profit from price discrepancies between the market price and the stock’s intrinsic value. The EMH claims the stock’s fair value, also called intrinsic value , is much the same as its market value , and finding undervalued or overvalued assets is non-viable.

Intrinsic value refers to an asset’s true, actual value, which is calculated using fundamental and technical analysis, whereas the market price is the currently listed price at which stock is bought and sold. When markets are efficient, the two values should be the same, but when they differ, it poses opportunities for investors to make an excess profit.

For markets to be completely efficient, all information should already be accounted for in stock prices and are trading on exchanges at their fair market value, which is practically impossible.

Hypothesis definition

A hypothesis is merely an assumption, an idea, or an argument that can be tested and reasoned not to be true. Something that isn’t fully supported by full facts or doesn’t match applied research.

For example, if sugar causes cavities, people who eat a lot of sweets are prone to cavities. And if the same applies here – if all information is reflected in a stock’s price, then its fair value should be the same as its market value and can not differ or be impacted by any other factors.

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Fundamental and technical analysis in an efficient market

According to the EMH, stock prices are already accurately priced and consider all possible information. If markets are fully efficient, then no fundamental or technical analysis can help investors find anomalies and make an extra profit.

Fundamental analysis is a method to calculate a stock’s fair or intrinsic value by looking beyond the current market price by examining additional external factors like financial statements, the overall state of the economy, and competition, which can help define whether the stock is undervalued.

Also relevant is technical analysis , a method of forecasting the value of stocks by analyzing the historical price data, mainly looking at price and volume fluctuations occurring daily, weekly, or any other constant period, usually displayed on a chart.

The efficient market theory directly contradicts the possibility of outperforming the market using these two strategies; however, there are three different versions of EMH, and each slightly differs from the other.

Three forms of market efficiency

The efficient market hypothesis can take three different forms , depending on how efficient the markets are and which information is considered in theory:

1. Strong form efficiency

Strong form efficiency is the EMH’s purest form, and it is an assumption that all current and historical, both public and private, information that could affect the asset’s price is already considered in a stock’s price and reflects its actual value. According to this theory, stock prices listed on exchanges are entirely accurate.

Investors who support this theory trust that even inside information can’t give a trader an advantage, meaning that no matter how much extra information they have access to or how much analysis and research they do, they can not exceed standard returns.

Burton G. Malkiel, a leading proponent of the strong-form market efficiency hypothesis, doesn’t believe any analysis can help identify price discrepancies. Instead, he firmly believes in buy-and-hold investing, trusting it is the best way to maximize profits. However, factual research doesn’t support the possibility of a strong form of efficiency in any market.

2. Semi-strong form efficiency

The semi-strong version of the EMH suggests that only current and historical public (and not private) information is considered in the stock’s listed share prices. It is the most appropriate form of the efficient market hypothesis, and factual evidence supports that most capital markets in developed countries are generally semi-strong efficient.

This form of efficiency relies on the fact that public news about a particular stock or security has an immediate effect on the stock prices in the market and also suggests that technical and fundamental analysis can’t be used to make excess profits.

A semi-strong form of market efficiency theory accepts that investors can gain an advantage in trading only when they have access to any unknown private information unknown to the rest of the market.

3. Weak form efficiency

Weak market efficiency, also called a random walk theory, implies that investors can’t predict prices by analyzing past events, they are entirely random, and technical analysis cannot be used to beat the market.

Random walk theory proclaims stock prices always take a randomized path and are unpredictable, that investors can’t use past price changes and historical data trends to predict future prices, and that stock prices already reflect all current information.

For example, advocates of this form see no or limited benefit to technical analysis to discover investment opportunities. Instead, they would maintain a passive investment portfolio by buying index funds that track the overall market performance.

For example, the momentum investing method analyzes past price movements of stocks to predict future prices – it goes directly against the weak form efficiency, where all the current and past information is already reflected in their market prices.

A brief history of the efficient market hypothesis

The concept of the efficient market hypothesis is based on a Ph.D. dissertation by Eugene Fama , an American economist, and it assumes all prices of stocks or other financial instruments in the market are entirely accurate.

In 1970, Fama published this theory in “Efficient Capital Markets: A Review of Theory and Empirical Work,” which outlines his vision where he describes the efficient market as: “A market in which prices always “fully reflect” available information is called “efficient.”

Another theory based on the EMH, the random walk theory by Burton G. Malkiel , states that prices are completely random and not dependent on any factor. Not even past information, and that outperforming the market is a matter of chance and luck and not a point of skill.

Fama has acknowledged that the term can be misleading and that markets can’t be efficient 100% of the time, as there is no accurate way of measuring it. The EMH accepts that random and unexpected events can affect prices but claims they will always be leveled out and revert to their fair market value.

What is an inefficient market?

The efficient market hypothesis is a theory, and in reality, most markets always display some inefficiencies to a certain extent. It means that market prices don’t always reflect their true value and sometimes fail to incorporate all available information to be priced accurately.

In extreme cases, an inefficient market may even lead to a market failure and can occur for several reasons.

An inefficient market can happen due to:

A lack of buyers and sellers;
Absence of information;
Delayed price reaction to the news;
Transaction costs;
Human emotion;
Market psychology.

The EMH claims that in an efficiently operating market, all asset prices are always correct and consider all information; however, in an inefficient market, all available information isn’t reflected in the price, making bargain opportunities possible.

Moreover, the fact that there are inefficient markets in the world directly contradicts the efficient market theory, proving that some assets can be overvalued or undervalued, creating investment opportunities for excess gains.

Validity of the efficient market hypothesis

With several arguments and real-life proof that assets can become under- or overvalued, the efficient market hypothesis has some inconsistencies, and its validity has repeatedly been questioned.

While supporters argue that searching for undervalued stock opportunities using technical and fundamental analysis to predict trends is pointless, opponents have proven otherwise. Although academics have proof supporting the EMH, there’s also evidence that overturns it.

The EMH implies there are no chances for investors to beat the market, but for example, investing strategies like arbitrage trading or value investing rely on minor discrepancies between the listed prices and the actual value of the assets.

A prime example is Warren Buffet, one of the world’s wealthiest and most successful investors, who has consistently beaten the market over more extended periods through value investing approach, which by definition of EMH is unfeasible.

Another example is the stock market crash in 1987, when the Dow Jones Industrial Average (DJIA) fell over 20% on the same day, which shows that asset prices can significantly deviate from their values.

Moreover, the fact that active traders and active investing techniques exist also displays some evidence of inconsistencies and that a completely efficient market is, in reality, impossible.

Contrasting beliefs about the efficient market hypothesis

Although the EMH has been largely accepted as the cornerstone of modern financial theory, it is also controversial. The proponents of the EMH argue that those who outperform the market and generate an excess profit have managed to do so purely out of luck, that there is no skill involved, and that stocks can still, without a real cause or reason, outperform, whereas others underperform.

Moreover, it is necessary to consider that even new information takes time to take effect in prices, and in actual efficiency, prices should adjust immediately. If the EMH allows for these inefficiencies, it is a question of whether an absolute market efficiency, strong form efficiency, is at all possible. But as this theory implies, there is little room for beating the market, and believers can rely on returns from a passive index investing strategy.

Even though possible, proponents assume neither technical nor fundamental analysis can help predict trends and produce excess profits consistently, and theoretically, only inside information could result in outsized returns.

Moreover, several anomalies contradict the market efficiency, including the January anomaly, size anomaly, and winners-losers anomaly, but as usual, factual evidence both contradicts and supports these anomalies.

Parting opinions about the different versions of the EMH reflect in investors’ investing strategies. For example, supporters of the strong form efficiency might opt for passive investing strategies like buying index funds. In contrast, practitioners of the weak form of efficiency might leverage arbitrage trading to generate profits.

Marketing strategies in an efficient and inefficient market

On the one side, some academics and investors support Fama’s theory and most likely opt for passive investing strategies. On the other, some investors believe assets can become undervalued and try to use skill and analysis to outperform the market via active trading.

Passive investing

Passive investing is a buy-and-hold strategy where investors seek to generate stable gains over a more extended period as fewer complexities are involved, such as less time and tax spent compared to an actively managed portfolio.

People who believe in the efficient market hypothesis use passive investing techniques to create lower yet stable gains and use strategies with optimal gains through maximizing returns and minimizing risk.

Proponents of the EMH would use passive investing, for example:

Invest in Index Funds;
Invest in Exchange-traded Funds (ETFs).

However, it is important to note that other mutual funds also use active portfolio management intending to outperform indices, and passive investing strategies aren’t only for those who believe in the EMH.

Active investing

Active portfolio managers use research, analysis, skill, and experience to discover market inefficiencies to generate a higher profit over a shorter period and exceed the benchmark returns.

Generally, passive investing strategies generate returns in the long run, whereas active investing can generate higher returns in the short term.

Opponents of the EMH might use active investing techniques, for example:

Arbitrage and speculation;
Momentum investing ;
Value investing .

The fact that these active trading strategies exist and have proven to generate above-market returns shows that prices don’t always reflect their market value.

For instance, if a technology company launches a new innovative product, it might not be immediately reflected in its stock price and have a delayed reaction in the market.

Suppose a trader has access to unpublished and private inside information. In that case, it will allow them to purchase stocks at a much lower value and sell for a profit after the announcement goes public, capitalizing on the speculated price movements.

Passive and active portfolio managers are often compared in terms of performance, e.g., investment returns, and research hasn’t fully concluded which one outperforms the other,

Efficient market examples

Investors and academics have divided opinions about the efficient market hypothesis, and there have been cases where this theory has been overturned and proven inaccurate, especially with strong form efficiency. However, proof from the real world has shown how financial information directly affects the prices of assets and securities, making the market more efficient.

For example, when the Sarbanes-Oxley Act in the United States, which required more financial transparency through quarterly reporting from publicly traded businesses, came into effect in 2002, it affected stock price volatility. Every time a company released its quarterly numbers, stock market prices were deemed more credible, reliable, and accurate, making markets more efficient.

Example of a semi-strong form efficient market hypothesis

Let’s assume that ‘stock X’ is trading at $40 per share and is about to release its quarterly financial results. In addition, there was some unofficial and unconfirmed information that the company has achieved impressive growth, which increased the stock price to $50 per share.

After the release of the actual results, the stock price decreased to $30 per share instead. So whereas the general talk before the official announcement made the stock price jump, the official news launch dropped it.

Only investors who had inside private information would have known to short-sell the stock , and the ones who followed the publicly available information would have bought it at a high price and incurred a loss.

What can make markets more efficient?

There are a few ways markets can become more efficient, and even though it is easy to prove the EMH has no solid base, there is some evidence its relevance is growing.

First , markets become more efficient when more people participate, buy and sell and engage, and bring more information to be incorporated into the stock prices. Moreover, as markets become more liquid, it brings arbitrage opportunities; arbitrageurs exploiting these inefficiencies will, in turn, contribute to a more efficient market.

Secondly , given the faster speed and availability of information and its quality, markets can become more efficient, thus reducing above-market return opportunities. A thoroughly efficient market, strong efficiency, is characterized by the complete and instant transmission of information.

To make this possible, there should be:

Complete absence of human emotion in investing decisions;
Universal access to high-speed pricing analysis systems;
Universally accepted system for pricing stocks;
All investors accept identical returns and losses.

The bottom line

At its core, market efficiency is the ability to incorporate all information in stock prices and provide the most accurate opportunities for investors; however, it isn’t easy to imagine a fully efficient market.

Research has shown that most developed capital markets fall into the semi-strong efficient category. However, whether or not stock markets can be fully efficient conclusively and to what degree continues to be a heated debate among academics and investors.

Disclaimer: The content on this site should not be considered investment advice. Investing is speculative. When investing, your capital is at risk.

FAQs on the efficient market hypothesis

The efficient market hypothesis (EMH) claims that prices of assets such as stocks are trading at accurate market prices, leaving no opportunities to generate outsized returns. As a result, nothing could give investors an edge to outperform the market, and assets can’t become under- or overvalued.

What are three forms of the efficient market hypothesis?

The efficient market hypothesis takes three forms: first, the purest form is strong form efficiency, which considers current and past information. The second form is semi-strong efficiency, which includes only current and past public, and not private, information. Finally, the third version is weak form efficiency, which claims stock prices always take a randomized path.

What contradicts the efficient market hypothesis?

The efficient market hypothesis directly contradicts the existence of investment strategies, and cases that have proved to generate excess gains are possible, for example, via approaches like value or momentum investing.

When more investors engage in the market by buying and selling, they also bring more information that can be incorporated into the stock prices and make them more accurate. Moreover, the faster movement of information and news nowadays increases accuracy and data quality, thus making markets more efficient.

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Efficient Market Hypothesis: Strong, Semi-Strong, and Weak

If I were to choose one thing from the academic world of finance that I think more individual investors need to know about, it would be the efficient market hypothesis.

The name “efficient market hypothesis” sounds terribly arcane. But its significance is huge for investors, and (at a basic level) it’s not very hard to understand.

So what is the efficient market hypothesis (EMH)?

As professor Eugene Fama (the man most often credited as the father of EMH) explains*, in an efficient market, “the current price [of an investment] should reflect all available information…so prices should change only based on unexpected new information.”

It’s important to note that, as Fama himself has said, the efficient market hypothesis is a model, not a rule. It describes how markets tend to work. It does not dictate how they must work.

EMH is typically broken down into three forms (weak, semi-strong, and strong) each with their own implications and varying levels of data to back them up.

Weak Efficient Market Hypothesis

The weak form of EMH says that you cannot predict future stock prices on the basis of past stock prices. Weak-form EMH is a shot aimed directly at technical analysis. If past stock prices don’t help to predict future prices, there’s no point in looking at them — no point in trying to discern patterns in stock charts.

From what I’ve seen, most academic studies seem to show that weak-form EMH holds up pretty well. (Take, for example, the recent study which tested over 5,000 technical analysis rules and showed them to be unsuccessful at generating abnormally high returns.)

Semi-Strong Efficient Market Hypothesis

The semi-strong form of EMH says that you cannot use any published information to predict future prices. Semi-strong EMH is a shot aimed at fundamental analysis. If all published information is already reflected in a stock’s price, then there’s nothing to be gained from looking at financial statements or from paying somebody (i.e., a fund manager) to do that for you.

Semi-strong EMH has also held up reasonably well. For example, the number of active fund managers who outperform the market has historically been no more than can be easily attributed to pure randomness .

Semi-strong EMH does not appear to be ironclad, however, as there have been a small handful of investors (e.g., Peter Lynch, Warren Buffet) whose outperformance is of a sufficient degree that it’s extremely difficult to explain as just luck.

The trick, of course, is that it’s nearly impossible to identify such an investor in time to profit from it. You must either:

Invest with a fund manager after only a few years of outperformance (at which point his/her performance could easily be due to luck), or
Wait until the manager has provided enough data so that you can be sure that his performance is due to skill (at which point his fund will be sufficiently large that he’ll have trouble outperforming in the future).

Strong Efficient Market Hypothesis

The strong form of EMH says that everything that is knowable — even unpublished information — has already been reflected in present prices. The implication here would be that even if you have some inside information and could legally trade based upon it, you would gain nothing by doing so.

The way I see it, strong-form EMH isn’t terribly relevant to most individual investors, as it’s not too often that we have information not available to the institutional investors.

Why You Should Care About EMH

Given the degree to which they’ve held up, the implications of weak and semi-strong EMH cannot be overstated. In short, the takeaway is that there’s very little evidence indicating that individual investors can do anything better than simply buy & hold a low-cost, diversified portfolio .

*Update: The video from which this quote came has since been taken offline.

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A good point to keep in mind is that even if the EMH models aren’t a perfect model of the stock market- if it is close enough that technical analysis or fundamental analysis won’t give you a real advantage then it doesn’t make sense to try them. A Random Walk Down Wall Street: The Time-Tested Strategy for Successful Investing presents that case very well.

-Rick Francis

Wonderfully concise summary, Mike.

Just for completeness, re: the Semi-Strong EMH, there’s a third option – you could try to invest in stocks and beat the market yourself.

I know, I know – but before I get my hat I’d argue that there’s benefits to this approach over picking one or more active fund managers, in that your dealing charges *may* be lower than the fund’s charges (and at least they’re transparent and under your control) and also you don’t have to try to predict two potentially understandable things – a manager’s performance AND the performance of the sort of stocks he invests in (or even a third – whether he or she is going to stick around).

Of course, a tracker fund sidesteps all of this for most people to deliver better than average results compared to funds, and only slightly worse results compared to the market. 🙂

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Home > Finance > Semi-Strong Form Efficiency: Definition And Market Hypothesis

Semi-Strong Form Efficiency: Definition And Market Hypothesis

Published: January 26, 2024

Learn about semi-strong form efficiency in finance and understand its definition and market hypothesis. Discover how it impacts investment decisions.

Definition starting with S

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Semi-Strong Form Efficiency: Definition and Market Hypothesis Explained

Welcome to our finance blog post where we delve into the fascinating world of market efficiency. In particular, we are going to explore the concept of Semi-Strong Form Efficiency, a fundamental theory in finance. Have you ever wondered whether the stock market truly reflects all available information? What impact do public announcements or news events have on stock prices? We will uncover the answers to these questions and more in this article.

Key Takeaways:

Semi-Strong Form Efficiency suggests that stock prices already incorporate all publicly available information.
Efficient market hypothesis states that it is impossible to consistently achieve above-average market returns using only publicly available information.

What is Semi-Strong Form Efficiency?

Semi-Strong Form Efficiency is a concept that forms a significant part of the Efficient Market Hypothesis. It posits that stock prices accurately reflect all publicly available information. This means that analyzing historical market data or relying on recent news events will not provide an edge in generating consistent and above-average returns.

The theory of Semi-Strong Form Efficiency suggests that stocks adjust so quickly and accurately to new information that it becomes virtually impossible for investors to outperform the market based solely on publicly available information. Investors who attempt to beat the market by analyzing news events, company announcements, or financial statements are unlikely to consistently outperform the overall market in the long run.

To better understand this concept, let’s consider an example. Suppose a company releases its quarterly earnings report, which beats market expectations. In an environment of Semi-Strong Form Efficiency, this positive news will be quickly incorporated into the stock price. By the time the information becomes widely available, the stock price will already reflect the positive market sentiment, making it difficult for investors to profit solely from this news.

So, how does Semi-Strong Form Efficiency fit into the broader Efficient Market Hypothesis?

The Efficient Market Hypothesis (EMH) is a theory that states financial markets are efficient and that it is impossible to consistently achieve above-average market returns using only publicly available information. EMH classifies market efficiency into three forms: weak, semi-strong, and strong.

Semi-Strong Form Efficiency lies in the middle of these three forms. It posits that not only are stock prices influenced by past market data (weak form), but they also reflect all publicly available information (semi-strong form). In its strongest form, market efficiency theory suggests that stock prices also incorporate private or insider information that is not available to the public.

The Implications of Semi-Strong Form Efficiency

The theory of Semi-Strong Form Efficiency has several implications for investors:

Efficient Market Hypothesis Challenges Active Management: As the Efficient Market Hypothesis suggests that investors cannot consistently outperform the market based on publicly available information, proponents argue that active stock picking and market timing are unlikely to lead to superior returns. This challenges the idea that professional fund managers or individual investors can beat the market consistently.
Focus on Other Investment Strategies: In light of Semi-Strong Form Efficiency, many investors turn to other strategies that do not rely solely on publicly available information. These strategies include passive investing (such as index fund investing) and alternative investment vehicles like private equity or hedge funds that may have access to additional information sources.
Importance of Fundamental Analysis: Although Semi-Strong Form Efficiency suggests that analyzing publicly available information may not consistently yield above-average returns, it does not render fundamental analysis useless. Understanding a company’s financials, industry trends, and competitive advantages can still provide valuable insights for long-term investment decision making and risk management.

In conclusion, Semi-Strong Form Efficiency is a critical concept within the field of finance. By acknowledging that stock prices efficiently reflect all publicly available information, investors can make more informed decisions and shape their investment strategies accordingly. While it challenges the ability to consistently outperform the market using publicly available data, it highlights the importance of alternative investment strategies and a comprehensive understanding of fundamental analysis.

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Moscow, like other international urban areas , is decentralizing, despite considerable barriers. The expansion will lead to even more decentralization, which is likely to lead to less time "stuck in traffic" and more comfortable lifestyles. Let's hope that Russia's urban development policies, along with its plans to restore population growth, will lead to higher household incomes and much improved economic performance.

Wendell Cox is a Visiting Professor, Conservatoire National des Arts et Metiers, Paris and the author of “ War on the Dream: How Anti-Sprawl Policy Threatens the Quality of Life ”

Note 1: The 23 ward (ku) area of Tokyo is the geography of the former city of Tokyo, which was abolished in the 1940s. There is considerable confusion about the geography of Tokyo. For example, the 23 ward area is a part of the prefecture of Tokyo, which is also called the Tokyo Metropolis, which has led some analysts to think of it as the Tokyo metropolitan area (labor market area). In fact, the Tokyo metropolitan area, variously defined, includes, at a minimum the prefectures of Tokyo, Kanagawa, Chiba and Saitama with some municipalities in Gunma, Ibaraki and Tochigi. The metropolitan area contains nearly three times the population of the "Tokyo Metropolis."

Note 2: The expansion area (556 square miles or 1,440 square kilometers) has a current population of 250,000.

Note 3: Includes all residents in suburban districts with at least part of their population in the urban area.

Note 4: Urban area data not yet available.

Photo: St. Basil's Cathedral (all photos by author)

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Evolving Urban Form: Development Profiles of World Urban Areas
Transportation

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Road in city area.

The roads and ways of the city areas are very clumsy and many accidents are happening due to the short road. But you need to maintain the driving properly otherwise you may face accident. So now the government decided to expand the road which may put the positive effect on automobile sector. I think it is a helpful service for the society people. If you have a BMW car and you have faced any problem then better to repair it at BMW Repair Spring, TX for the best service.

Transit & transportation

Transit and transportation services are quite impressive in most of the urban cities; therefore people were getting better benefits from suitable transportation service. Urban cities like Moscow, Washington, New York and Tokyo; we have found high margin of transportation system that helps to build a better communication network in these cities. I hope through the help of modern transportation system we are able to bring revolutionary change in automobile industries; in this above article we have also found the same concepts to develop transportation system. Mercedes repair in Torrance

Moscow is bursting Noblesse

Moscow is bursting Noblesse at the seams. The core city covers more than 420 square miles (1,090 kilometers), and has a population of approximately 11.5 million people. With 27,300 residents per square mile (10,500 per square kilometer), Moscow is one percent more dense than the bleach anime watch city of New York, though Moscow covers 30 percent more land. The 23 ward area of Tokyo (see Note) is at least a third more dense, though Moscow's land area is at least half again as large as Tokyo. All three core areas rely

Belgravia Villas is a new

Belgravia Villas is a new and upcoming cluster housing located in the Ang Mo Kio area, nested right in the Ang Mo Kio landed area. It is within a short drive to Little India, Orchard and city area. With expected completion in mid 2016, it comprises of 118 units in total with 100 units of terrace and 18 units of Semi-D. belgravia villas

Russians seeing the light while Western elites are bickering?

What an extremely interesting analysis - well done, Wendell.

It is also extremely interesting that the Russian leadership is reasonably pragmatic about urban form, in contrast to the "planners" of the post-rational West.

An acquaintance recently sent me an article from "The New Yorker", re Moscow's traffic problems.

The article "abstract" is HERE (but access to the full article requires subscription)

http://www.newyorker.com/reporting/2010/08/02/100802fa_fact_gessen

One classic quote worth taking from it, is: "People will endure all manner of humiliation to keep driving".

I do find it odd that the "New Yorker" article author says nothing at all about the rail transit system Moscow had, on which everyone was obliged to travel, under Communism. It can't surely have vaporised into thin air?

Moscow is a classic illustration of just how outmoded rails are, and how important "automobility" is, when the auto supplants rails so rapidly than even when everybody did travel on rails up to a certain date, and the road network dates to that era, when nobody was allowed to own a car; an article written just 2 decades later does not even mention the rail transit system, other than to criticise the mayor for "failing to invest in a transit system".......!!!!!!!!

This is also a give-away of "The New Yorker's" inability to shake off the modern PC ideology on rails vs cars.

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Semi-Strong Form

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Weak, Semi-Strong, and Strong Efficiency

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Market Efficiency

Implications and Limitations of the Efficient Market Hypothesis

Efficient Market Hypothesis

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Efficient Markets Hypothesis (EMH)

What Is Efficient Market Hypothesis?

When did the Efficient Market Hypothesis first emerge?

How is the Efficient Market Hypothesis used in the real world?

Efficient Market Hypothesis (EMH)

Written by True Tamplin, BSc, CEPF®

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Types of Efficient Market Hypothesis

Weak Form EMH

Semi-strong Form EMH

Strong Form EMH

Assumptions of the Efficient Market Hypothesis

All Investors Have Access to All Publicly Available Information

All Investors Have a Rational Expectation

Investors React Instantly to New Information

Implications of the Efficient Market Hypothesis

Implications for Individual Investors

Implications for Portfolio Managers

Implications for Corporate Finance

Implications for Government Regulation

Criticisms and Controversies Surrounding the Efficient Market Hypothesis

Behavioral Finance and the Challenge to EMH

Market Anomalies and Inefficiencies

Financial Crises and the Question of Market Efficiency

Empirical Evidence of the Efficient Market Hypothesis

Evidence Supporting EMH

Evidence Against EMH

Efficient Market Hypothesis in Modern Finance

EMH and the Rise of Passive Investing

Impact of Technology on Market Efficiency

Future of EMH in Light of Evolving Financial Markets

Efficient Market Hypothesis (EMH) FAQs

What are the three forms of the Efficient Market Hypothesis (EMH)?

How does the Efficient Market Hypothesis (EMH) impact individual investors and portfolio managers?

What are some criticisms of the Efficient Market Hypothesis (EMH)?

How does the Efficient Market Hypothesis (EMH) influence modern finance and its future?

True Tamplin, BSc, CEPF®

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