There is evidence to support the reasoning behind the efficient market hypothesis, but the basic conclusion drawn from the theory does not logically follow from it and is mistaken. The efficient market hypothesis essentially theorizes that market efficiency causes stock prices to accurately reflect all available information at any given time.

The strongest version of the theory is that all relevant information for stock share prices is already reflected in the current market price.

Key Takeaways

  • The efficient market hypothesis theorizes that market efficiency causes stock prices to reflect all available information at any given time.
  • The hypothesis holds that all public information is reflected in share prices, which is supported by price moves following earnings reports.
  • However, the conclusion that investors can't find undervalued stocks or beat the market is flawed.
  • Despite the same public information, there are many examples of well-known investors that have outperformed the overall market.

How Efficient Market Hypothesis Works

A somewhat less ambitious variation of the theory is that all relevant public information is always reflected in market share prices and the market nearly instantly adjusts for any previously private or insider information once it becomes publicly known. In essence, market trading is efficient in that it leads to the current market price at any given point in time, accurately reflecting the actual value of a stock or other investment asset.

One of the conclusions from EMH is that the market can't be beaten consistently by investors since all information is priced in. Therefore, the theory holds that is should be impossible to outperform the overall market by picking stocks, analyzing financial statements, or through market timing. As a result, EMH proponents argue that the only way investors can beat the overall market is to buy riskier investments.

How Efficient Market Hypothesis Can Be Correct

Evidence from market action certainly supports the theory when viewing how the financial markets react to the release of information and the decline in popularity of actively-managed investments by portfolio managers.

Information that's Priced Into the Market

A common occurrence in the markets is the release of what is interpreted as negative news for a market being followed not by a drop in price but by basically a non-reaction followed by a rise in price. Traders and analysts frequently explain this away by saying the market already priced in the bad news prior to its public release.

Earnings Releases

Also, as companies release their annual or quarterly earnings reports, the markets respond to that information once they're released. The stock price might rise or fall depending on the current earnings results or the earnings forecasts by a company's management team.

Index Funds

The rise of index funds has garnered support for the efficient market hypothesis. Index funds are a collection of stocks or securities that mirror an underlying index that it tracks. For example, an exchange-traded fund (ETF) might contain all of the stocks that are in the S&P 500 index. These are passively managed funds, meaning there isn't an active portfolio or investment manager picking stocks in an attempt to beat the market. If the S&P goes up or down, the ETF that tracks it will go up or down by the same percentage. Over the years, index funds have outperformed many actively managed funds, supporting the efficient market hypothesis.

How Efficient Market Hypothesis Can Be Incorrect

However, even if the hypothesis is essentially correct, the major conclusions that are drawn from the hypothesis have been challenged and in some cases, proven incorrect.

Flawed Conclusions

The premise that it's impossible for a trader to "beat the market" consistently has been proven incorrect. The theory is that since market price always reflects actual market value, meaning an investor couldn't buy an undervalued stock, for example. In other words, while a stock might appear undervalued, it is in fact properly valued at any given point in time. From this conclusion, which is a bit questionable in itself, subscribers to the efficient market hypothesis then make the unwarranted, illogical leap to the broader conclusion that market efficiency means that no investor can consistently outperform the overall market average return on investment.

Such a definitive conclusion about possible investor performance simply does not logically follow from the premises of the theory. Even granting the idea that current market share price always accurately reflects actual market value, this does not preclude the possibility of a given individual investor or portfolio manager being able to consistently profit from the changes in market price that do occur. There is nothing in the efficient market hypothesis theory that logically leads to the conclusion that it is not possible for an investor or analyst to, for example, perform fundamental analysis and accurately speculate before the fact on the widespread success of Internet usage and make a fortune by buying Google stock at $30 a share.

Beating the Market

Numerous investors have demonstrated their ability to consistently outperform the market over time, including Paul Tudor Jones, John Templeton, George Soros, and Warren Buffett. While there is evidence that market price at any given time does indeed efficiently incorporate all relevant information, facts show it is a mistake, an error in logic, to draw the conclusion that shrewd investors cannot consistently outperform the market.