A large section of traders and investors use fundamental and technical analysis techniques to identify current and future price movements of assets. While the general consensus is that these two techniques are quite useful for planning trading strategies, there’s also another segment of traders who believe in the other side of the coin – the efficient market hypothesis. If you’re wondering what this concept entails, then here’s what you need to know.
What is the efficient market hypothesis (EMH)?
Also known as the market efficiency theory, the efficient market hypothesis assumes that any and all available information related to an asset is already factored into its current price. This effectively means that an asset always trades at its fair value, making it impossible to identify undervalued or overvalued stocks.
The efficient market hypothesis essentially states that any new information that arises with respect to an asset is instantly accounted for by the market. It assumes that the market is so efficient that it is capable of quickly factoring the impact of the new information in the prices of the assets. It also states that irrespective of how many analytical techniques you use, as a trader or an investor, it is simply not possible to beat or gain an edge over the ‘market.’
Efficient market hypothesis: An example
Let’s take a look at an example to understand this concept in a better manner.
Assume that there’s a stock of a company ‘ABC Limited’. The shares of the company are currently trading at Rs. 100 each. You conduct a thorough fundamental analysis of the company including reading its financials for the past years and conclude that the company is performing quite well. And so, you finally decide to buy its shares.
But, in another scenario, assume that instead of trying to determine whether the company’s current share price of Rs. 100 is overvalued or undervalued, you assume that the current price is the fair value of the stock. You effectively assume that the current price of Rs. 100 per share already factors the company’s good financial performance. Therefore, any further increases in the stock price beyond Rs. 100 is likely to happen only if there are any new developments or unexpected positive news.
This assumption that you made is just what the market efficiency theory states. A company’s current or past performance would not bring about any future increases in its stock price since the performance has already been accounted for by the market.
Types of market efficiency theory
With respect to the efficient market hypothesis, there are three primary types of variations. Let’s take a look at each of them in detail.
According to this variation of the market efficiency theory, an asset’s price has already accounted for all of the available information in the public domain. However, the price of the asset may not account for new information that has not yet been released to the public.
Another assumption that the weak form of efficient market hypothesis makes is that the historical information of an asset has no impact on the said asset’s future price movements. As a result, this variation completely disregards the concept of technical analysis but leaves room for fundamental analysis.
The semi-strong variation is another one of the types of market efficiency theory. It basically takes all the assumptions made by the weak form and builds on it. What this variation essentially states is that any new information about an asset that’s made public is almost always instantly factored into its prices by the market.
And so, this form not only disregards technical analysis, but also dismisses the concept of fundamental analysis as well. A good example of this is the outcome of the RBI monetary policy regarding the country’ repo rate. As soon as the repo rate is declared, the markets instantly react to it with the prices of stocks adjusting in line with the announcement.
As the name itself implies, this is by far the strongest variation of the efficient market hypothesis. This form makes the assumption that the prices of an asset reflect all related information, be it public or private.
According to this variation, all of the past and present information that’s available both in the public and the private (the insiders) domain is automatically assumed to be accounted for by the price of the asset. This essentially means that no one, not even those with confidential insider information, can ever hope to beat the market.
While you may be tempted to disregard the concepts of fundamental and technical analysis, be sure to remember that the efficient market hypothesis is just a theory. The assumptions made by the different types of market efficiency theories holds true only in some cases and not in all of them. And so, it is advisable to not downplay the impact of fundamental and technical analysis when it comes to helping you take informed decisions.