The efficient markets hypothesis (EMH) is an organizing principle for understanding how markets work and what investors should care about. Professor Eugene F. Fama of the University of Chicago performed extensive research on stock price patterns. In 1966, he developed the efficient markets hypothesis, which asserts that:
•Securities prices reflect all available information and expectations
•Current prices are the best approximation of intrinsic value
•Price changes are due to unforeseen events
•Stock prices follow a random walk and are not predictable
•Although stocks may be mis-priced at times, this condition is hard to recognize.
The most important premise of the efficient market is not that new information is disseminated rapidly but that not all traders translate new information in the same way. For instance, one investor may believe an excellent earnings report from Apple makes the stock a buy; another may feel that the stock has nowhere to go but down the following quarter. This example is repeated thousands of times daily in markets around the world. Stock picking experts and research analysts compete aggressively to find stocks they believe to be over or under-valued to trade for profit.
If new information is the main driver of prices, only unexpected events will trigger price changes. This may be one reason that stock prices seem to behave randomly over the short term.
Viewing the markets as efficient has important implications. If current market prices offer the best available estimate of intrinsic value, stock mis-pricing should be regarded as a rare condition that cannot be systematically exploited through analysis and forecasting. Market efficiency argues that when securities become mis-priced, market forces quickly push prices back toward fair value.
No matter how powerful a trader’s analytical tools, or how sophisticated their understanding of the industries they study, or how deep their knowledge of consumer and market trends, the fact is it is very difficult for traders to beat the market by gathering and analyzing information.
If professionals with virtually unlimited resources cannot apply research and analysis to pick winning stocks, it is even less likely that individuals can outperform the market. The futility of speculation is good news for the investor. It means that prices for public securities are fair and that persistent differences in average portfolio returns are explained by differences in average risk.
Market efficiency does not rule out the possibility that some investors will earn above-normal returns. Over any period of time, some investors will beat the market, but the number of investors who do so, will be no greater than expected by chance and not without accepting increased risk.
The efficient markets hypothesis implies that: no investor will consistently outperform the stock market except by chance, and investors may be best served through passively structured portfolios. Rather than trying to out-research other market participants, a passive investor looks to asset class diversification to manage uncertainty and position for long-term growth in the capital markets.
It may be hard to conceive current stock prices as rational, especially when markets are extremely volatile. The efficient markets hypothesis does not claim that markets are always rational or correctly factor information into prices. The only condition required is that a large number of market participants do not consistently exploit price differences to outperform the market average.