What Is the Efficient Market Hypothesis (EMH)?

The efficient market hypothesis (EMH), alternatively known as the efficient market theory, is a hypothesis that states that share prices reflect all information and consistent alpha generation is impossible.

According to the EMH, stocks always trade at their fair value on exchanges, making it impossible for investors to purchase undervalued stocks or sell stocks for inflated prices. Therefore, it should be impossible to outperform the overall market through expert stock selection or market timing, and the only way an investor can obtain higher returns is by purchasing riskier investments.

Key Takeaways

  • The efficient market hypothesis (EMH) or theory states that share prices reflect all information.
  • The EMH hypothesizes that stocks trade at their fair market value on exchanges.
  • Proponents of EMH posit that investors benefit from investing in a low-cost, passive portfolio.
  • Opponents of EMH believe that it is possible to beat the market and that stocks can deviate from their fair market values.
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Efficient Market Hypothesis

Understanding the Efficient Market Hypothesis

Although it is a cornerstone of modern financial theory, the EMH is highly controversial and often disputed. Believers argue it is pointless to search for undervalued stocks or to try to predict trends in the market through either fundamental or technical analysis.

Theoretically, neither technical nor fundamental analysis can produce risk-adjusted excess returns (alpha) consistently, and only inside information can result in outsized risk-adjusted returns.

$342,850

The January 10, 2020 share price of the most expensive stock in the world: Berkshire Hathaway Inc. Class A (BRK.A).

While academics point to a large body of evidence in support of EMH, an equal amount of dissension also exists. For example, investors such as Warren Buffett have consistently beaten the market over long periods, which by definition is impossible according to the EMH.

Detractors of the EMH also point to events such as the 1987 stock market crash, when the Dow Jones Industrial Average (DJIA) fell by over 20 percent in a single day, and asset bubbles as evidence that stock prices can seriously deviate from their fair values.

Special Considerations

Proponents of the Efficient Market Hypothesis conclude that, because of the randomness of the market, investors could do better by investing in a low-cost, passive portfolio.

Data compiled by Morningstar Inc., in its June 2019 Active/Passive Barometer study, supports the EMH. Morningstar compared active managers’ returns in all categories against a composite made of related index funds and exchange-traded funds (ETFs). The study found that over a 10 year period beginning June 2009, only 23% of active managers were able to outperform their passive peers. Better success rates were found in foreign equity funds and bond funds. Lower success rates were found in US large cap funds. In general, investors have fared better by investing in low-cost index funds or ETFs.

While a percentage of active managers do outperform passive funds at some point, the challenge for investors is being able to identify which ones will do so over the long-term. Less than 25 percent of the top-performing active managers can consistently outperform their passive manager counterparts over time.