You must have heard stock market pundits often emphasizing on the importance of research and finding the value in a stock. There will be people out there vouching for their expertise with fundamental or technical analysis. However, there is a 0theory in the market that rubbishes all these claims. It’s called the efficient market hypothesis (EMH).
EMH as the name suggests is a hypothetical theory. It essentially says that all known information is already factored into the stock price. Hence, no amount of analysis can give one investor an edge over the other.
As per the EMH theory, stocks always trade at their fair value on exchanges. Hence, it is impossible for investors to purchase undervalued stocks. Or, sell stocks for inflated prices.
It raises a few direct questions on popular analysis techniques. It asserts that with all new information priced in, neither technical nor fundamental analysis can generate excess returns. Therefore, it should be impossible to outperform the overall market. And, the only way an investor can generate higher returns is by purchasing riskier investments.
Forms of EMH:
There are three forms of EMH: weak, semi-strong, and strong. Here’s what each says about the market.
Weak Form EMH:
This form suggests that today’s stock prices reflect all the data of past prices. And technical analysis can not effectively help investors in making trading decisions.
It further believes that fundamental analysis can help investors to generate above-average returns in the short term. But, there are no fixed patterns that exist. Thus, the fundamental analysis does not provide any long-term advantage.
This efficiency theory suggests that since all the available information is factored in the current market price, no technical or fundamental analysis helps to generate higher returns in the market.
However, this form believes that there is some information that is not publicly available. Such information can help investors to generate above-average returns.
Strong Form EMH:
This version of the theory says that all information, both public and private, is priced into stocks. And no investor can gain an advantage over the market as a whole.
It says that investors can’t generate returns higher than the normal market returns. No matter what information they have or research they conducted.
This theory, though widely popular, is not free from contradictory views. One may argue that if every piece of information is factored in, the prices should stay stable and not keep changing every second. Also, sharp movement and volatility should not exist if that is the case.
This theory holds merit for stocks that are well covered by analysts. However, the companies that are not extensively covered are often priced incorrectly. Many small-cap companies falling in this bracket have managed to generate alpha returns.
Even momentum investing brings the loopholes of this theory to the forefront. Beaten-down stocks have often generated alpha when they are in momentum. This momentum can be based on fundamentals like the return of a favorable business cycle. Or, can be technical like increased volume or activity. This theory even fails to capture behavioral aspects like change in sentiments or change in perception.
All said and done, this theory is based on the premise that the market is a forward-looking animal. A company is judged on its future potential and past performances do not matter.
Your investment grows if the company grows. Hence, investors are better off investing in futuristic themes and companies that have a long growth runway ahead of them.