Different investors use various investment theories to support their decision where to put their money. Some investors believe in the Efficient Market Hypothesis (EMH), while others choose to be more aggressive and beat the market.
What is the Efficient Market Hypothesis
Also known as EMH in financial terms, this hypothesis is an investment theory developed by Eugene Fama. It provided the foundation for more modern risk-based approaches of asset prices. This theory states that it is impossible for a consistent alpha generation, and that share prices reflect all information. For instance, agents must employ rational expectations. It also assumes that, in general, the population is correct, and when new pertinent information comes out, the agent must adjust their expectations accordingly. EMH is founded on the fact that the market price of shares already incorporated all the known information about it. A particular stock will change its price depending on future events that will directly affect that stock.
EMH assumes that most investors, either overreact or underreact when presented with new information. EMH requires its investors to react randomly and follow a regular distribution pattern. Through this, no one can exploit the market prices to make huge profits. It assumes that one person can be wrong about the market, but the general market is always right.
By theory, none of the fundamental or technical analysis can result in risk-adjusted excess returns or alpha. Only inside information should cause enormous risk-adjusted gains. EMH purports that the stocks are always trading using their fair value on the stock exchange market. This fair value trading makes it nonviable for investors to sell shares with boosted prices or buy undervalued stocks. Therefore, it is inconceivable for the investors to outperform the general market by market timing or through excellent stock selection. EMH claims that investors can only get higher returns when they buy high-risk investments.
Those who follow this theory hold a wide array of investments and make a profit when there is an overall growth in the market.
What are the Forms of the Efficient Market Hypothesis?
This form of EMH states that analysing past prices is not enough to predict future performance because prices do not have serial dependencies. Asset prices do not have patterns. As a result, price movements will only change based on current information available about the share.
In a semi-strong-form EMH, there is an assumption that share prices will adjust accordingly based on any new publicly available information. This price change will proceed in an unbiased fashion, so investors will not earn any excess returns as a result. For this to happen, price changes must be rapid and instantaneous. There must be consistent upward or downward adjustments after the initial movement. If no adjustment occurs, it would highly suggest that investors interpreted the information with bias.
This form of EMH states that the current share prices are a reflection of all private and public information. Thus, no one can earn excess returns from it.
In conclusion, EMH believers assume that there exists randomness in the market. Due to this, the only way they can profit is by investing in a low-cost and passive portfolio.