Britannica Money (2024)

One of the most controversial topics in finance is the efficient-market hypothesis, developed by Eugene Fama in 1965. In a nutshell, the theory says that the financial markets are efficient, so no one can gain an edge in them.

Fama’s paper “The Behavior of Stock-Market Prices,” which was published in the Journal of Business, doesn’t use the term efficient-market hypothesis. Rather, it says that “… a situation where successive price changes are independent is consistent with the existence of an ‘efficient’ market for securities, that is, a market where, given the available information, actual prices at every point in time represent very good estimates of intrinsic values.”

That line set off a theoretical explosion in university economics departments. At first, Wall Street ignored the idea of market efficiency because it contradicted the work of most analysts and brokers. But the evidence became too strong to ignore, and the efficient-market hypothesis is now generally accepted despite its weaknesses, including the inability at times to determine why the price of an asset has risen or fallen.

But just what is the efficient-market hypothesis? What are its key principles and its implications for investors?

Three forms of efficient-market hypothesis

The efficient-market hypothesis says that financial markets are effective in processing and reflecting all available information with little or no waste, making it impossible for investors to consistently outperform the market based on information already known to the public. One area of debate is how strong the efficient-market hypothesis is. In 1970, Fama wrote another paper that explored the idea of market efficiency in more depth, noting that it seemed to take three forms:

• Weak-form efficiency: In this form, market prices reflect all past trading information, such as historical prices and trading volumes. According to weak-form efficiency, technical analysis (the study of past price and volume data) cannot consistently generate excess returns because this information is already reflected in stock prices.
• Semi-strong-form efficiency: This idea says that all publicly available information, including news and past trading data, is fully reflected in stock prices. As a result, neither technical analysis nor fundamental analysis (the study of financial statements and economic factors) can consistently beat the market, because all available information is already incorporated into prices.
• Strong-form efficiency: The most robust version of the efficient-market hypothesis contends that all information, public and private, is fully reflected in stock prices. In other words, no individual or group of investors possesses information that can consistently yield superior returns. This form of efficiency suggests that insider trading is futile in the long run, as insider information is also reflected in stock prices.

What the efficient-market hypothesis means for investors

The biggest implication of the efficient-market hypothesis is that index funds and other passive investing strategies offer better risk-adjusted returns after fees than active investment. At an extreme, it suggests that doing research and analysis is no better than picking stocks at random.

One assumption in the efficient-market hypothesis is that information is distributed immediately throughout the market. In 1965, that seemed ridiculous and formed one critique of the model, but financial services companies soon realized that speed pays off. The sooner someone could find an anomaly and act on it, the faster they could lock in a profit. Today, brokerages and market makers tie their servers directly to securities exchanges to shave milliseconds from execution times.

Criticisms and limitations

Despite its significance, the efficient-market hypothesis is not without criticisms and limitations. Some critics argue that several factors prevent markets from being perfectly efficient, including:

• Behavioral biases—errors in judgment, decision-making, and thinking when evaluating information.
• Information asymmetry—where one person has more or better information than someone else.
• Market frictions—anything that interferes with market transactions, including transaction costs, taxes, regulation, and information glitches.

Naysayers point to market bubbles, crashes, and persistent anomalies as evidence against strong market efficiency. An entire field of finance, behavioral economics, has developed to explore how market participants are inefficient.

Another criticism of the efficient-market hypothesis is that certain valuation anomalies persist, even though the hypothesis says they shouldn’t. One is that small companies tend to outperform larger ones; another is that value stocks tend to outperform those with higher price-to-earnings (P/E) ratios. In 1992, Fama and Kenneth French published a paper showing that those anomalies were real and should be incorporated into financial valuation models.

Validation on a large scale

The efficient-market hypothesis remains a cornerstone of financial theory and has had a profound influence on investment strategies, portfolio management, and the understanding of financial markets. Although its three forms provide an accepted framework for thinking about market efficiency, the debate about its validity continues.

Investors and researchers alike grapple with the ever-evolving nature of financial markets, where the balance between efficiency and inefficiency remains a subject of ongoing study and discussion. Regardless of your stance on the efficient-market hypothesis, it has undeniably shaped how we approach investing and market analysis today.

The bottom line

In 2013, Fama received the Nobel Prize for his work. The market has accepted the efficient-market hypothesis, and index investing has revolutionized the financial industry. One of Fama’s students, David Booth, started an investment company specializing in index investing for institutional clients (such as pension funds and insurance companies). Booth was so successful—and so grateful—that he donated $300 million to the University of Chicago in 2008. In exchange, the university named its business school after him. Talk about a legacy.

References

• The Behavior of Stock-Market Prices | jstor.org
• Efficient Capital Markets: A Review of Theory and Empirical Work | jstor.org
• Common Risk Factors in the Returns on Stocks and Bonds | sciencedirect.com
• Eugene F. Fama – Facts | nobelprize.org