Investment Theory and Portfolio Development - Efficient Market Hypothesis (EMH)
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:
- 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.
- 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.
- 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.
- 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:
- Price/Earnings Ratio - firms trading at lower P/E multiples tend to generate higher returns.
- Neglected Firm Effect - companies with little or no analyst coverage may be mispriced, presenting an opportunity for the stock picker to generate alpha.
- 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.
- 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.
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.