The theory posits that markets are efficient for the most part, assimilating new information on stock prices and that investors in consequence should be unable to outperform the market consistently. Additionally, due to the random nature of stock prices, attempts to extrapolate events into the future are futile. Equity prices reflect all that is known. There are three versions of the hypothesis:

  1. Weak Form - based only on historical information (trading volume, prices, financial data), it is difficult to outperform the market. This version of the hypothesis refutes the merits of technical analysis. Fundamental analysis and insider information could help investors outperform the market.
  2. Semi-Strong Form - current stock prices reflect all historical data and analysis of financial statements. Because stock prices rapidly incorporate any new information, under this version of the hypothesis, bottom-up fundamental analysis would not help investors outperform the market.
  3. Strong Form - stock prices reflect all information, be it historical stock data, financial statement analysis or insider information. Investors would be unable to outperform the market consistently as a result.
  4. Anomalies - these are the sorts of behavior for which the various versions of the EMH cannot account and which would appear to contradict it. Among the more common are:

    1. Price/Earnings Ratio - firms trading at lower P/E multiples tend to generate higher returns.
    2. Neglected Firm Effect - companies with little or no analyst coverage may be mispriced, presenting an opportunity for the stock picker to generate alpha.
    3. January Effect - stock prices experience an upsurge in January. Possible reinvestment after tax-loss selling in December of the prior year could be a proximate cause.
    4. Value Line Enigma - a stock research service, Value Line ranks stocks by the degree to which they are desirable to own in ascending order from 1 to 5. Stocks with a 1 ranking tend to outperform the market.

Behavioral Finance
Antithetical to the notion of efficient markets and rational investor behavior, this discipline posits that investors are irrational in their reaction to market events and in their conduct as investors. The implication is that cognitive biases could influence asset prices. If the behavior of the market would appear not to make sense, then one need only look to the conduct of investors for an explanation. Once viewed as heretics, proponents of this study of investor behavior are recognized for their contributions to finance and investment.


Fundamental Analysis

Related Articles
  1. Investing

    Efficient Market Hypothesis: Is The Stock Market Efficient?

    Deciding whether it's possible to attain above-average returns requires an understanding of EMH.
  2. Investing

    Is Stock Picking A Myth?

    Find out if mutual fund managers can successfully pick stocks or if you're better off with an index fund.
  3. Investing

    Modern Portfolio Theory vs. Behavioral Finance

    Modern portfolio theory and behavioral finance represent differing schools of thought that attempt to explain investor behavior. Perhaps the easiest way to think about their arguments and positions ...
  4. Insights

    The Efficient Market Hypothesis: Settling the Great Debate

    An understanding of neuroscience and the decision-making process provides a resolution to the decades-old debate between proponents and critics of the Efficient Market Hypothesis.
  5. Investing

    Hypothesis Testing in Finance: Concept & Examples

    When you're indecisive about an investment, the best way to keep a cool head might be test various hypotheses using the most relevant statistics.
  6. Investing

    What is a Null Hypothesis?

    In statistics, a null hypothesis is assumed true until proven otherwise.
  7. Investing

    Mad Money ... Mad Market?

    Jim Cramer's spirited recommendations are a case study in irrational market behavior.
  8. Investing

    Seven Market Anomalies Investors Should Know

    Though they're unpredictable and heavily contested, market anomalies can often work in an investor's favor.
Frequently Asked Questions
  1. What are the Differences Among a Real Estate Agent, a broker and a Realtor?

    Learn how agents, realtors, and brokers are often considered the same, but in reality, these real estate positions have different ...
  2. What is the difference between amortization and depreciation?

    Because very few assets last forever, one of the main principles of accrual accounting requires that an asset's cost be proportionally ...
  3. Which is better, a fixed or variable rate loan?

    A variable interest rate loan is a loan in which the interest rate charged on the outstanding balance varies as market interest ...
  4. What is the 1003 mortgage application form?

    Learn about the 1003 mortgage application form, what information it requires and why this form is the industry standard for ...
Trading Center