A:

Though the efficient market hypothesis as a whole theorizes that the market is generally efficient, the theory is offered in three different versions: weak, semi-strong and strong.

The basic efficient market hypothesis of investment posits that the market cannot be beaten because it incorporates all important determinative information into current share prices . Therefore, stocks trade at the fairest value, meaning that they can't be purchased undervalued or sold overvalued. The theory determines that the only opportunity investors have to gain higher returns on their investments is through purely speculative investments that pose substantial risk.

The three versions of the efficient market hypothesis are varying degrees of the same basic theory. The weak form suggests that today’s stock prices reflect all the data of past prices and that no form of technical analysis can be effectively utilized to aid investors in making trading decisions. Advocates for the weak form efficiency theory allow that if fundamental analysis is used, undervalued and overvalued stocks can be determined, and investors can research companies' financial statements to increase their chances of making higher-than-market-average profits.

The semi-strong form efficiency theory follows the belief that because all information that is public is used in the calculation of a stock's current price, investors cannot utilize either technical or fundamental analysis to gain higher returns in the market. Those who subscribe to this version of the theory believe that only information that is not readily available to the public can help investors boost their returns to a performance level above that of the general market.

The strong form version of the efficient market hypothesis states that all information – both the information available to the public and any information not publicly known – is completely accounted for in current stock prices, and there is no type of information that can give an investor an advantage on the market. Advocates for this degree of the theory suggest that investors cannot make returns on investments that exceed normal market returns, regardless of information retrieved or research conducted.

There are anomalies that the efficient market theory cannot explain and that may even flatly contradict the theory. For example, the price/earnings (P/E) ratio shows that firms trading at lower P/E multiples are often responsible for generating higher returns. The neglected firm effect suggests that companies that are not covered extensively by market analysts are sometimes priced incorrectly in relation to true value and offer investors the opportunity to pick stocks with hidden potential. The January effect shows historical evidence that stock prices tend to experience an upsurge in January.

Though the efficient market hypothesis is an important pillar of modern financial theories and has a large backing, primarily in the academic community, it also has a large number of critics. The theory remains controversial, and investors continue attempting to outperform market averages with their stock selections.

RELATED FAQS
  1. What is an efficient market and how does it affect individual investors?

    When people talk about market efficiency they are referring to the degree to which the aggregate decisions of all the market's ... Read Answer >>
  2. What does the efficient market hypothesis assume about fair value?

    Found out what the efficient market hypothesis says about the fair value of securities, and learn why technical and fundamental ... Read Answer >>
  3. What's the difference between agency theory and stakeholder theory?

    Learn how agency theory and stakeholder theory are used in business to understand common business communication problems ... Read Answer >>
  4. What is the chaos theory?

    The chaos theory is a complicated and disputed mathematical theory that seeks to explain the effect of seemingly insignificant ... Read Answer >>
  5. Why are financial markets considered to be transparent?

    Understand the efficient market hypothesis and how it relates to financial markets. Learn why financial markets are considered ... Read Answer >>
  6. Why is Game Theory useful in business?

    Game theory was once hailed as a revolutionary interdisciplinary phenomenon bringing together psychology, mathematics, philosophy ... Read Answer >>
Related Articles
  1. Investing

    Market Efficiency Basics

    Market efficiency theory states that a stock’s price will fully reflect all available and relevant information at any given time.
  2. Investing

    Efficient Market Hypothesis

    An investment theory that states it is impossible to "beat the market".
  3. Investing

    Efficient Market Hypothesis: Is The Stock Market Efficient?

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

    What Is Market Efficiency?

    The efficient market hypothesis (EMH) suggests that stock prices fully reflect all available information in the market. Is this possible?
  5. Trading

    Manipulating Facts to Fit a Theory: A Dangerous Trading Practice

    This practice is common with experienced and new traders, and it can lead to huge losses. Find out how to avoid it.
RELATED TERMS
  1. Semi-Strong Form Efficiency

    A class of EMH (Efficient Market Hypothesis) that implies all ...
  2. Price Efficiency

    The premise that asset prices are efficient, to the extent that ...
  3. Informationally Efficient Market

    A theory, which moves beyond the definition of the efficient ...
  4. Weak Form Efficiency

    One of the different degrees of efficient market hypothesis (EMH) ...
  5. Strong Form Efficiency

    The strongest version of market efficiency. It states all information ...
  6. Mechanism Design Theory

    An economic theory that seeks to determine the situations in ...
Hot Definitions
  1. Nostro Account

    A bank account held in a foreign country by a domestic bank, denominated in the currency of that country. Nostro accounts ...
  2. Retirement Planning

    Retirement planning is the process of determining retirement income goals and the actions and decisions necessary to achieve ...
  3. Drawdown

    The peak-to-trough decline during a specific record period of an investment, fund or commodity. A drawdown is usually quoted ...
  4. Inverse Transaction

    A transaction that can cancel out a forward contract that has the same value date.
  5. Redemption

    The return of an investor's principal in a fixed income security, such as a preferred stock or bond; or the sale of units ...
  6. Solvency

    The ability of a company to meet its long-term financial obligations. Solvency is essential to staying in business, but a ...
Trading Center