Is the Efficient Market Hypothesis (EMH) applicable to the stock market?

Efficient Market Hypothesis (EMH)

When new information comes out, it can cause stock prices to change. The Efficient Market Hypothesis says that this new information is quickly reflected in stock prices. This means that studying past stock prices or a company's financial information won't help you make more money than someone who just picks stocks randomly. So, the EMH raises doubts about whether you can predict the stock market.

Investors are always trying to make money by finding stocks that are priced wrong. They want to buy low and sell high. But as more and more people try to do this, it becomes harder to find those mispriced stocks. Only a few analysts will be successful, while most investors will end up losing money because the costs of buying and selling stocks will be more than the profits they make.

So, why do people still use these analyses to make investment decisions if they don't actually help them beat the market? That's a question we'll explore in this article.

Forms of Efficient Market Hypothesis

The Efficient Market Hypothesis says that the prices of stocks show all the information that's out there. This information can change depending on which version of the EMH you're looking at.

1. Weak Form Efficiency

So, like, the weak form of the market efficiency thingy says that all the info about past stock prices is already included in the current prices. That means looking at old prices and stuff won't help you figure out if a stock is priced wrong. 'Cause everyone already knows the prices, so it's hard to make money off of that. Basically, using technical analysis won't help you do better than the market because what happened in the past doesn't really affect what's happening now.

2. Semi-Strong Form Efficiency

The semi-strong form of market efficiency says that all the information available to the public is already factored into stock prices. This includes things like a company's financial reports, news about dividends and earnings, and even news about mergers with other companies. Just like with weak form efficiency, nobody can make money by using this public information to predict stock prices. The only difference is that semi-strong form efficiency is even stricter than weak form efficiency. This means that no one can beat the stock market by analyzing financial data or using technical strategies.

3. Strong Form Efficiency

So, there's this idea called the strong form of market efficiency hypothesis. Basically, it says that all information, whether it's public or private (like insider info), is already factored into the prices of stocks. This means that nobody can really beat the market, even if they have secret info that hasn't been shared with everyone else yet. So, if a company's bosses buy up a bunch of their own company's stock because they think they're about to make a big profit, they won't actually make any extra money. And even if a research team discovers something groundbreaking, they won't be able to cash in on that info either. The strong form of market efficiency hypothesis says that the market is always looking ahead and taking all information into account when setting stock prices. So, the prices you see are probably pretty fair and based on all available info, not just what the insiders know.

 Evidence against the EMH

 1. Behavioral Finance: Rationality vs. Irrationality

Have you ever heard of behavioral finance? It's a theory that goes against the idea of the EMH. The efficient market hypothesis says that stock prices will always be fair because everyone gets information at the same time and makes smart decisions. But behavioral finance says that even though everyone gets the same info, people still make mistakes when they invest. They might let their emotions or biases get in the way of making good choices. One common bias is called loss aversion, where people hold onto a bad investment because they don't want to admit they made a mistake. This can lead to big losses. So, even though we all have the same info, our emotions can still mess up our investment decisions.

2. Overreaction and Underreaction

When investors hear new information about a company, they are supposed to make smart decisions based on that info. But sometimes, people get too excited or too scared and make mistakes. This can cause the prices of stocks to be wrong, which is called mispricing. Basically, if a company does well and makes money, its stock price goes up. But if it does poorly, the stock price goes down. This happens because people get too happy or too sad about the news. Some experts think that stock prices should be based more on how much money a company will make in the future, rather than just how much money it's making now. This is shown by something called the price to earnings ratio. If a stock has a low ratio, it might be a good deal. But if it has a high ratio, it might be too expensive. People buy stocks based on how much they think they can make, which can lead to them getting too excited or too scared.

In a fair market, stock prices show all the information available, and it's really hard to do better than the market by looking at old data. So, trying to guess how much money you'll make by looking at old data questions the idea of a fair market. Studies have shown that stocks that did poorly in the past end up doing better in the long run, and this is because investors tend to overreact. On the other hand, stocks that did well in the past tend to keep doing well, and this is because investors don't react enough. This is called the "Overreaction" and "Underreaction" effect, and it makes people wonder if the market is really fair. It suggests that investors might make money by buying stocks that did poorly in the past and selling stocks that did well (contrarian strategies) in the long run, or by buying stocks that did well in the past and selling stocks that did poorly (momentum or relative strength strategies) in the short run.

3. Fair Pricing

The EMH states that stock prices in the market are fair and reflect the decisions of investors. But not all investors act the same way. Just like people have different opinions and preferences, investors have different strategies because they like different things. Some take big risks with their investments, while others play it safe. Investors have different goals and ways of thinking, so they don't all look at stocks the same way. Some people argue that it's impossible to know how much a stock is really worth in an efficient market because everyone values stocks differently.

4. Against Strong Form Efficiency

The idea behind the strong form efficiency hypothesis is that the current price of a stock already includes all the information out there, whether it's public or private. This means that even if someone on the inside of a company knows something big before it's announced to the public, they shouldn't be able to make a profit by trading stocks based on that information. But sometimes, insiders do end up making money this way. If a company's employees discover something really important, like a new product that will make a lot of money, word can spread quickly. People outside the company might catch wind of this news and buy stocks before the big announcement, making a profit when the stock price goes up. So, even though the strong form efficiency hypothesis says insiders shouldn't profit from private information, some studies have shown that they do.

5. Professional Investment Managers, Mutual Funds Consistently Outperforming the Market

Investors try different ways to figure out which stocks are undervalued and will do better than the overall market. But the EMH says that these methods don't really work, and no one can consistently beat the market.

On the flip side, some experts who manage other people's money and mutual funds have been able to beat the stock market for a really long time by using fancy analysis techniques. Take Warren Buffet, for example. He's a regular guy who's made a ton of money by buying stocks that were selling for less than they were really worth. Some investment managers have a better track record than others, and some research teams are better at predicting which stocks will do well. But some people believe in something called the Efficient Market Hypothesis, which basically says that it's all just luck - in a big market, some people will do better than average, while others will do worse.

6. Value Vs. Growth

The EMH states that it's really hard to beat the stock market because prices change super fast when new information comes out. But some people use a different strategy called value investing. This means they look for stocks that are priced lower compared to their book value, dividends, or past prices. And guess what? These value stocks can actually do better than the overall market! Studies have shown that stocks with low price to book ratios (value stocks) tend to have higher returns than stocks with high price to book ratios (glamour stocks). Basically, people tend to think glamour stocks will grow more in the future than they actually do. So, this goes against what EMH says about the market always being efficient.

Conclusion

Basically, a lot of research shows that it's really hard to beat the stock market by trying to pick the best stocks. It's better to just invest in a bunch of different stocks and not try to outsmart everyone else. Some people still don't believe this idea though, because they think they can do better by picking certain stocks.