The Efficient Markets Hypothesis Explained in Simple Terms

An efficient capital market is characterized by the rapid adjustment of security prices to the arrival of new information so that they reflect this information and enable investors to make well-informed investment decisions. Investors enter a capital market to buy or sell a security at a certain price that is justified by the prevailing supply and demand. To determine appropriate price, the market participants should be able to acquire timely and accurate information on the volume and price of past transactions. These historical data determine current bids and offers.

The efficient market hypothesis (EMH) holds that investors, who buy securities at efficient prices, should be provided with accurate information and should receive a rate of return that implicitly includes the perceived risk of the security. The fundamental value of securities is the present value of the expected cash flows that investors will receive in the future. To anticipate these cash flows, the market should reflect all new available information in current security prices so that investors may use this information as the best forecasting tool of future value. The term "new information" implies information that was not known before and could not be predictable, because if it was predictable it would have been integrated in the security prices. In this aspect, securities trade at their fair value protecting investors from buying undervalued stocks or selling overvalued stocks.

Given that in an efficient market, participants actively compete and seek for profit maximization on the grounds of accurate prediction of future cash flows of individual securities, EMH assumes that an efficient market requires (1) large numbers of profit-maximizing participants, who analyze and value securities, (2) new information regarding individual securities, and (3) profit-maximizing investors, who adjust security prices upon release of new information. The combined effect of above tree assumptions leads to the conclusion that in efficient markets, current security prices reflect all currently available information including the risk of the security.

EMH is divided in three sub-hypotheses, namely (1) the weak-form market hypothesis, (2) the semistrong-form market hypothesis and (3) the strong-form market hypothesis

Weak-form efficient market hypothesis

The weak-form efficient market hypothesis assumes that current security prices reflect all the information available in the market including the historical price data, total trading volume data, and rates of return. Since the hypothesis assumes that security prices already reflect past information, it implies that the future rates of return should not depend on historical data, but instead, they should be independent. Consequently, in order to gain from buying or selling their securities, investors should not base their decisions on technical analysis or the study of past rates of return.

Semistrong-form efficient market hypothesis

The semistrong-form efficient market hypothesis assumes that security prices adjust quickly to the new information available in the market and they reflect all public information, namely historical price data, total trading volume data, rates of return, earnings, dividend payments, price/earnings (P/E) ratios, book value (B/V) ratios, market value (M/V) ratios, stock splits, and economical and political news. Since the hypothesis assumes that security prices reflect all public information, it implies that investors, who buy or sell securities based on new public information, should expect profits that reflect an average risk-rate of return after trading costs are calculated since the new public information is already incorporated in security prices. Therefore, investors base their investment decision making on fundamental analysis and the study of a firm' financial statements.

Strong-form efficient market hypothesis

The strong-form efficient market hypothesis assumes that that security prices reflect all both public and private information available. The strong-form efficient market hypothesis integrates both the weak-form EMH and semistrong-form EMH assuming perfect markets. Information is cost-free and no group of investors can control the market with monopolistic access to information. Therefore, investors cannot base their investment decisions on technical analysis, fundamental analysis or inside information, but on the other hand they should consistently expect profits that reflect an above average risk-rate of return.

According to EMH, it is impossible for investors to beat the market since stock prices reflect all relevant information. Since stocks always trade at their fair value, it is practically impossible for investors to buy undervalued stocks or sell overvalued stocks. In this context, EMH has been challenged from the advocates of traditional finance, who assert that outperforming the market through selection of specific shares is impossible. It is generally impossible to outperform the market as a whole either through expert stock selection or market timing. The only way investors can gain higher returns is by undertaking higher risk.