Efficient Market Hypothesis (EMH): the basics
About this lesson
In this video, I am going to discuss four aspects of stock market efficiency: The random walks model, the Efficient market hypothesis, implications of the EMH, Stock Market Anomalies, and whether markets are Efficient.
Random walks
If prices already reflect everything known, they only change when new information arrives. News is unpredictable by definition, so price changes should be unpredictable too, a random walk. That’s not a sign of irrational markets; it’s what you’d expect when competition among investors quickly prices in any information.
The efficient market hypothesis
The EMH says that stock prices fully reflect available information. It comes in three forms:
| Form | Prices reflect | So this can’t consistently beat the market |
|---|---|---|
| Weak | All past prices and trading data | Technical analysis (chart patterns) |
| Semi-strong | All public information, including financial statements and news | Fundamental analysis of public data |
| Strong | All information, including private (insider) information | Even insider information |
Most evidence supports the weak form fairly well, the semi-strong form partly, and rejects the strong form: insiders trading on private information (which is illegal) can profit.
What it means for investors
- If markets are efficient, picking stocks or timing the market is unlikely to beat a low-cost index fund after fees.
- That’s the argument for passive investing.
- Even in an efficient market, portfolio management still matters: diversification, matching risk to your goals, and keeping taxes and costs low.
Anomalies
Researchers have found patterns that seem to contradict the EMH, at least for some periods:
- Momentum: recent winners keep winning for a few months.
- Size and value effects: small companies and those with low price-to-book ratios have earned higher average returns.
- Post-earnings announcement drift: prices keep moving in the direction of an earnings surprise for weeks.
- Calendar effects such as the January effect.
Whether these are true inefficiencies or rewards for extra risk is debated, and many weaken once they become widely known.
Are markets efficient?
Mostly, but not perfectly. Few professional managers beat their benchmark consistently over long periods, which suggests markets are hard to beat. Bubbles and crashes suggest prices can drift from fundamentals for a while.
Next chapter: options markets for beginners.