Efficient Market Hypothesis (EMH)

The efficient market hypothesis (EMH) is the theory that prices in financial markets fully and quickly reflect the information available about the assets traded. If it holds, no investor can reliably beat the market, after allowing for risk and costs, by studying past prices, public news or company reports, because that information is already built into the market price. Prices then move mainly in response to new, unpredictable information, so their path looks close to random.

The hypothesis is most closely associated with Eugene Fama of the University of Chicago, whose 1970 review article set out its modern form. Earlier roots include Louis Bachelier's 1900 thesis on price movements and Paul Samuelson's 1965 proof that properly anticipated prices fluctuate randomly. Fama shared the 2013 Nobel Memorial Prize in Economic Sciences with Robert Shiller, one of the hypothesis's best-known critics, and Lars Peter Hansen, which shows how unsettled the debate remains.

Picture a busy farmers' market where hundreds of shoppers are hunting for bargains. If one stall sells excellent tomatoes at a low price, word spreads fast, a queue forms, and either the tomatoes sell out or the price goes up. By the time you hear about the bargain, it is usually gone.

The EMH says stock markets are like that, only faster and with far more shoppers. Thousands of professional investors are constantly looking for mispriced shares, and their buying and selling pushes prices to where the known facts suggest they should be. A tip that everyone already knows is worth nothing, because it is already in the price.

Fama distinguished three versions, depending on which information is assumed to be priced in:

• Weak form. Prices reflect all past prices and trading volumes, so chart-reading techniques, including indicators such as the relative strength index, should not produce consistent excess returns.
• Semi-strong form. Prices adjust quickly to all public information, such as earnings announcements and economic data, so studying published reports should not help either.
• Strong form. Prices reflect even private information. Few defend this version, and laws against insider trading exist precisely because insiders can profit from what the market does not yet know.

Testing any form requires a model of what a "normal" return is, such as the Capital Asset Pricing Model (CAPM). Fama called this the joint-hypothesis problem: an apparent anomaly may mean markets are inefficient, or simply that the model of risk is wrong.

The strongest practical support comes from the record of professional investors. S&P Dow Jones Indices' SPIVA scorecards have repeatedly found that most actively managed US equity funds trail their benchmark index over periods of ten years or more, and the funds that do well in one period rarely keep it up; studies that ignore closed funds overstate results through survivorship bias. Event studies also show prices reacting to news within minutes or seconds, a speed increased by algorithmic trading. This evidence helped the growth of index funds, starting with Vanguard's first index fund in 1976, and of passive management through exchange-traded funds.

• Excess volatility. Robert Shiller showed in 1981 that stock prices swing far more than later dividends would justify, suggesting that prices are moved by changing sentiment, not only by news.
• Bubbles and crashes. Episodes such as the 1987 crash, the dot-com boom and the run-up to the 2008 financial crisis are hard to square with prices always reflecting fundamental value; see economic bubble.
• Anomalies. Researchers documented persistent patterns such as momentum (recent winners keep winning for a time), the value effect and the small-firm effect. Defenders argue these are rewards for hidden risks or disappear once known and traded.
• Behavioral finance. Work by Daniel Kahneman, Amos Tversky, Richard Thaler and others in behavioral economics shows systematic errors such as overconfidence and loss aversion that could push prices away from fair value.
• Limits to arbitrage. Arbitrage is supposed to correct mispricing, but it is costly and risky; short sellers can be squeezed out before a bubble bursts.
• The Grossman–Stiglitz paradox. Sanford Grossman and Joseph Stiglitz argued in 1980 that if prices reflected all information perfectly, nobody would pay to gather it, so markets must be slightly inefficient to reward the research that makes them nearly efficient.

Most economists now see efficiency as a matter of degree. Large, liquid markets such as major government bonds and big-company shares are hard to beat after costs, while small, opaque or illiquid markets offer more room for skill. Andrew Lo's adaptive markets hypothesis (2004) describes efficiency as changing over time as investors learn and conditions shift. The EMH connects to the theory of rational expectations in macroeconomics, and it remains a starting point for regulators, for active managers trying to justify their fees, and for anyone measuring alpha.

• The Nobel Prize: 2013 Prize in Economic Sciences press release (Fama, Hansen, Shiller)