Are you an active investor?
Or let’s rephrase this question.
Do you believe that you can outperform the financial market on a regular basis through active investing? If yes, then let us introduce you to the efficient market theory, which says you can’t.
Experts regard the efficient market theory as a foundation of modern finance. The theory supports the idea of passive investing, as investors don’t have any unfair advantages in the market. Thus, they would be better off investing in index funds.
In this article, let us explore the concept of this theory and the core principle behind it.
Buckle up and keep going.
What Is an Efficient Market Theory in Economics?
Professor Eugene Fama conceived the idea of Efficient Market Theory (EMT). It’s also referred to as Efficient Market Hypothesis (EMH). It was initially conceptualized for assessing the stock market. But it also applies to other markets like cryptos, commodities, etc.
The core argument of EMT is that investors can’t beat the market. It’s because, in an efficient market, stock prices reflect all available information. The asset will ‘quickly’ correct itself to its intrinsic value if it’s undervalued or overvalued. It means none of the market participants would have an undue advantage due to high information availability. Thus, it is almost impossible for an investor to make above-average returns in an efficient market by trading financial assets.
In contrast, an inefficient market provides many opportunities to outperform the broader market returns. In this market, a section of investors would have exclusive information to take advantage of. Also, factors other than business fundamentals influence security prices. Thus, it tends to create bubbles.
For instance, in 2021, stocks like GameStop and AMC Theatres were heavily bought by retail investors to retaliate against the institutional investors who shorted these stocks. In fact, both stocks were not fundamentally strong. These kinds of instances happen a lot in an inefficient market.
Three Types of Efficient Market Theory
There are three different types of efficient market theory.
Each differs based on how informed the sector or market is at any given time.
1. Strong form
The strong form is the ideal version of the efficient market theory. It follows the belief that all ‘public’ and ‘private’ information is already absorbed into the stock price. No extra information is available for the investor to gain an advantage in the market.
Advocates of this form believe that investors can’t exceed average market returns, regardless of information retrieved or research conducted. They claim that fundamental analysis, technical analysis, and investment advisory services are worthless. The best way to earn money from the market is to adopt the buy-and-hold strategy.
2. Semi-strong form
The semi-strong form suggests that the stock price reflects all ‘public’ information available to the market participants. Thus, retail investors can’t use either fundamental or technical analysis to gain higher returns in the market.
But those with access to private or insider information could outperform the market.
3. Weak form
Weak form believes that no historical data points affect the stock’s price. These data points include price, volume, earnings data, etc.
Also, one can’t use past data to predict future value. In this case, no trader can gain an edge from technical analysis.
But, the weak form states that stock prices reflect the current information. Thus, the supporters of this form believe that one can determine undervalued or overvalued stocks only using fundamental analysis. Plus, they can increase the chance of making higher than market average profits by researching companies and financial statements.
Features of EMH
As per the efficient market hypothesis (EHM), below are the features of a perfectly efficient market.
1. Stock price
People trade stocks at their fair market value in a perfectly efficient market. The asset price reflects all relevant information, including current and historical data points.
2. Readily-available information
All market-related information is available to every investor. Thus, none of them have an undue advantage over others to profit from. Also, disclosing new information improves market efficiency further, reducing any arbitrage opportunities for investors.
3. Investor behavior
In an efficient market, investors behave in a rational manner. Even when they don’t, their irrational behaviors will have little effect on the market.
4. Opportunities for investors
The theory claims that retail investors can’t predict the future value of an asset consistently based on the current information and the history of the stock. It is because all the investors have the same information and invest based on it.
Apart from the stock market, we can also apply this theory to other markets. For instance, in an efficient labor market, all workers are paid the exact amount proportional to the value they contribute to their companies.
In an efficient crypto market, memecoins’ prices wouldn’t have oscillated based on random tweets from Elon Musk.
The Implication of EMH on Investment Strategy
The most significant implication of the EMH for retail investors is that they can’t consistently beat the market. Even if a particular stock pick gives good returns, it will not outperform anyone else’s over an extended timeframe.
Thus, the efficient market hypothesis suggests investing in index funds. Advocates of EMH are inclined to invest in passive index funds replicating the broader market’s performance. Index funds track the major market indices like Nifty, Sensex, or S&P 500.
This theory is one of the primary reasons behind the popularity of index or passive funds. Passive fund investors avoid taking huge risks, and they don’t prefer paying fees to the fund management group for investing. They believe the fund house can’t produce any outperforming results.
Advocates of the efficient market theory argue that it is often futile to look for undervalued stocks or try to predict future trends in the market using fundamental or technical analysis.
But it is not without its anomalies. Many well-known investors, including Benjamin Graham, John Templeton, Peter Lynch, Carl Icahn, Warren Buffet, Rakesh Jhunjhunwala, etc., have done an excellent job in outperforming the market.
It indicates that a perfectly efficient market doesn’t really exist. Thus, one should measure the efficiency of a market on a scale rather than using binary forms.
1. What determines market efficiency?
The number of market participants, depth of analyst coverage, and information availability determine market efficiency.
There are three different forms of market efficiency: Strong, Semi-Strong, and Weak. Each type’s efficiency depends on the information it uses to determine asset prices.
2. Who gave efficient market theory?
Professor Eugene Fama conceived the idea of Efficient Market Theory (EMT). It is also referred to as Efficient Market Hypothesis (EMH).
This theory was initially conceptualized for assessing the stock market. But it also applies to other markets like crypto, commodities, etc.