The Efficient Market Hypothesis

Introduction

The Efficient Market Hypothesis (EMH) is a market theory that helps explain why investors choose a passive investing strategy. At its core, the Efficient Market Hypothesis states that investment share prices reflect all information, so investment assets like stocks always trade at their fair value on exchanges and consistent risk-adjusted excess returns (alpha) generation are impossible. Supporters of the EMH believe that it is impossible for investors to sell inflated stocks or purchase undervalued stocks. Therefore, outperforming the market in the long-run through stock selection or market timing should not be possible.

The Efficient Market Hypothesis does not claim that investors cannot outperform the market in the short-run. There are always outlier assets. However, outliers exist in both directions, and the EMH states that in the long-run a portfolio performance always gravitates towards the market average.

Forms of the Efficient Market Hypothesis

In actuality, asymmetric information exists throughout the market, so the Efficient Market Hypothesis can be broken down into three forms based on the strength of the information priced into an asset. Each form provides different information about the market’s perceived efficiency.

Weak Form Efficiency

The weak form of the EMH claims that all information from historical prices is accounted for in the asset price. Therefore, investors cannot gain further insights from technical analysis, but they could capture a short-term above-average return from fundamental analysis. However, weak form efficiency states that future prices are unknowable based on past information because past information has been priced into the current price and has no impact on future prices. The randomness of prices means there are no price patterns, so there is no long-term advantage to be derived from technical analysis.

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Semi-Strong Form Efficiency

Semi-strong form efficiency assumes that all publicly available information about a stock is accounted for and instantly priced in. Because the stock price quickly adjusts to reflect all publicly available information, investors have nothing to gain from fundamental or technical analysis of public information. Investors can gain an edge from insider trading, but doing so is illegal.

Strong Form Efficiency

Strong form efficiency assumes that all information, public and non-public, is accounted for and instantly priced into the asset price. Because insider information is priced in, it is impossible for investors to gain an edge. Strong form efficiency assumes no one has access to monopolistic information, therefore the market is “perfectly efficient” at all times and excess returns cannot be realized.

Bitcoin and the Efficient Market Hypothesis

Bitcoin is a decentralized currency that is priced by supply and demand in the market. Because Bitcoin does not pay dividends and is not offered by a central authority, like traditional assets, information about the Bitcoin market is readily available and can be easily priced in. Therefore, Bitcoin is an efficient market that quickly reacts to public information.

Support for the Efficient Market Hypothesis

Supporters of the Efficient Market Hypothesis believe investors will benefit most from investing in a low-cost, passive portfolio and use the EMH as justification for buying passive mutual funds and exchange traded-funds. They believe technical and fundamental analysis will not help to predict trends or increase portfolio performance, and that the only way to outperform the market is through riskier investments.

Criticism of the Efficient Market Hypothesis

Opponents of the Efficient Market Hypothesis believe investors can outperform the market and that stocks do not always reflect their fair market value. Warren Buffet has consistently beaten the market for long-periods of time, which the Efficient Market Hypothesis claims should not be possible.