The efficient market hypothesis

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So far, we’ve seen how analysis and research can help you make smart trading and investment decisions. Logically, it does seem to hold true, isn’t it? That’s because we’ve assumed that various factors like historical data, financial information and other data points have an impact on the prices of stocks. Broadly speaking, there are three kinds of information that tend to affect the price of a stock, as we’ll see below.

Historical price data

This kind of information focuses solely on the past prices of the stocks in the market. By studying historical price patterns and the volume of the shares traded at those prices, analysts can predict possible future trends in stock prices. This is what the trading community labels as technical analysis. We’ll learn more about this kind of analysis in the upcoming modules.

Technical analysis uses various charting tools to identify short-term trends in the market. The underlying assumption in technical analysis is that past trading activity and price fluctuations can be useful indicators of how a stock’s price may move in the future. Technical analysis is generally useful for traders who wish to profit from short-term price changes. 

Publicly available information

This is a vast repository of information. It includes the financial data that’s available in a company’s financial statements, information that’s given out in the form of news and bulletins, as well as the general trends in the industry in which the company operates. The process of factoring in all of this public information to determine the intrinsic value of a stock is known as fundamental analysis.

In fundamental analysis, analysts disregard the current market prices of shares. Instead, they use publicly available information to determine the value of a stock. Then, they compare it with the market price to determine if the share is undervalued or overvalued.

Here’s an example.

  • Say the shares of company ABC Limited are trading in the market at Rs. 50 per share.
  • However, using the factors of fundamental analysis, analysts determine that the actual value of the stock should be, say Rs. 60. 
  • This means that the stock is currently undervalued on the market and so, there’s a potential for its market price to rise. 

That’s how fundamental analysis works. 

Private information

Private information, as the name signifies, is information that’s not yet available to the public. This may not really affect stock prices since the investors’ community is not aware of it yet. If such information is shared between two or more parties, it could lead to a minor impact on the prices. However, this is insider trading and it’s illegal. So, private information is not factored into either technical analysis or fundamental analysis.

Efficient Market Hypothesis: The other side of the coin

What if we played devil’s advocate and assumed that none of this information has any impact on the price of a stock? That’s what this market efficiency theory explores. Let’s look at an example to see how this kind of an assumption will impact your trading activity.

Scenario 1:

  • The stocks of company ABC Limited are now trading at, say Rs. 60 each. 
  • You study the financials of company ABC Limited for the past 5 financial years and see that it has been performing extremely well.
  • Further to this fundamental analysis, you come to the conclusion that the company’s stocks, now trading at Rs. 60 each, are undervalued.
  • So, you buy 100 stocks of the company because you assume that there’s a high chance that the stock prices will rise in the future and reflect the true value of the stock.
  • When they do rise, you can profit off the price movement.

Scenario 2:

  • The stocks of company ABC Limited are now trading at, say Rs. 60 each. 
  • You study the financials of company ABC Limited for the past 5 financial years and see that they’ve been performing extremely well.
  • However, this time, instead of assuming that this good financial performance is not reflected in the current stock prices, you assume that it is, in fact, already accounted for.
  • In other words, you assume that the stock price of Rs. 60 has already factored in the company’s financial performance.
  • So, any possible price increase in the future will only happen in case there’s any unexpected event or development. In other words, the company’s past or current performance will not result in any increase in the stock price in the future.

That’s exactly what the Efficient Market Hypothesis does. It assumes that share prices already reflect all relevant information.

What does the Efficient Market Hypothesis (EMH) say?

According to this market efficiency theory, any new information in the market is quickly reflected in the prices of the stocks and securities being traded. In other words, it says that the market is so efficient that it instantly incorporates all known information into the prices of the assets.

And since this is the same information that analysts use to identify stock market trends, they bring nothing new to the table. Why, you ask? Well, that’s because the market has already beaten them to it!

So, according to the EMH, no amount of analysis or research can give an investor an edge over another investor.

Forms of the Efficient Market Hypothesis

There are three forms of the Efficiency Market Hypothesis, each representing a different level of efficiency in the market.

Weak form 

  • This form of EMH assumes that the stock prices reflect all available public information.
  • It also disregards the assumption that past information regarding stock prices and trading volumes has any impact on future prices. 
  • So, it negates the validity of technical analysis and implies that technical trading strategies cannot provide significant returns because past prices cannot predict future trends. 

Semi-strong form

  • This form of EMH expands on what the weak form assumes. 
  • According to the semi-strong form of EMH, any new information that becomes publicly available is quickly and almost instantly, reflected in the prices of stocks.
  • So, it dismisses the use of fundamental analysis because such research does not have any power to predict the future movements in stock prices.

Strong form

  • The strong form of EMH assumes that the stock prices factor in all information – both public and private.
  • This includes all existing public information, newly available public information and private or insider information.
  • In other words, no investors, not even those who have insider knowledge of new developments, can gain an edge over other investors.

Wrapping up

Looking at the EMH, you may start to question the validity of technical analysis and fundamental analysis. Here’s where it’s important to keep in mind that the Efficient Market Hypothesis is just that – a hypothesis. If the assumptions that no investor has an edge over another is true, then, it should be impossible for anybody to consistently beat the market. However, that’s not the case, because many investors like Warren Buffet and Rakesh Jhunjhunwala have earned significant returns regularly.

The EMH has also earned many critics over the years. So, while it’s good to know the various theories out there, the importance of analysis and research cannot be underplayed. Data and information can help you make informed investment decisions. To know more about fundamental analysis and technical analysis, continue with the upcoming lessons and modules in Smart Money and see for yourself how they can help investors like you.

A quick recap

  • There are three kinds of information that tend to affect the price of a stock: historical price data, publicly available information and private information.
  • According to the Efficient Market Hypothesis, any new information in the market is quickly reflected in the prices of the stocks and securities being traded. 
  • In other words, it says that the market is so efficient that it instantly incorporates all known information into the prices of the assets.
  • According to the EMH, no amount of analysis or research can give an investor an edge over another investor.
  • The EMH has three variations, each representing a different level of efficiency in the market: the weak form, the semi-strong form and the strong form.
  • The weak form of EMH assumes that the stock prices reflect all available public information.
  • The semi-strong form of EMH assumes that any new information that becomes publicly available is quickly and almost instantly, reflected in the prices of stocks.
  • The strong form of EMH assumes that the stock prices factor in all information – both public and private.
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