The efficient market hypothesis (EMH) states that there is no way to “beat” the stock market since the market continuously adjusts price to reflect all available information. According to EMH it is best to invest in an index fund since in the long term it will incorporate all information. Ultimately, “playing the market,” i.e. trying to achieve a better return than the index, will be unsuccessful (Ross et al., 2013).
There are three forms of the efficient market hypothesis: the weak form, the semi-strong form, and the strong form. The three types differ by what information is included in the definition of “all available information.” In the weak form, “all available information” means historical prices, so that there is no relationship between historical prices (or rates of return) and future prices (rates); therefore, trading rules are useless because they are based on “patterns,” which, according to this form, do not exist (Borges, 2010).
The semi-strong form of the efficient market hypothesis considers all publicly available information to be contained in market at any given time (including historical information, as above). That is, the market is efficient, and any factors (such as news) that might cause a change in returns will be rapidly absorbed by the market. The news or other factor may cause a brief change but it will not last and it is generally impossible to determine how much and in which direction the change will be (Ross et al., 2013).
In the strong form, insider information is included (as well as historical and public news) such that no one can beat the market, not even those who have private information about companies, governments, commodities, etc. All three forms of EMH can be evaluated using statistics and other (usually mathematical) tests (Boboc & Dinica, 2013). Based partly on these tests, Sewell (2011) states that “strictly speaking, the EMH is false, but in spirit is profoundly true.”
If the EMH were true in the strictest sense, there would be no point in using either technical or fundamental analysis to guide trading (Sewell, 2011). Technical analysis is based on historical data such as price and volume; thus, it would be of little use even under the weak form of the EMH (Borges, 2010). Fundamental analysis provides information about specific companies, sectors, or indexes that includes more than price, volume, and similar data. The semi-strong form of the EMH states that this type of information, too, is useless. However, research has shown that some investors and traders do manage to beat the market, especially exchange specialists and individuals like Warren Buffett who have a lot of experience in the markets (Jarrow & Larsson, 2012; Open University, 2014). Therefore, the EMH is not 100% true — the stock market is not completely efficient — but it is probably more efficient than many investors and traders realize.
In some ways, playing the stock market is like informed gambling. For example, if one counts cards in blackjack or thoroughly knows the odds in poker or bridge, it is not gambling in the same sense as buying a lottery ticket — it is not completely random chance. Similarly, knowing information about a stock, index, or derivative may be helpful in making choices — not enough so that coming out ahead is certain, but enough so that it is not truly random (Epstein & Crotty, 2012).
There are many people who enjoy the thrill of gambling, and some of them play the stock market. They tend to choose more risky equities and other financial instruments, and as a result, they may experience greater losses (or gains). There is, however, social value to this type of investing / trading, even if the person does not intend it to be anything more than personally satisfying. The value is that this person’s trades help provide liquidity to the market, since every transaction must have both a buyer and a seller (Han & Kumar, 2013). Otherwise, many orders would go unfilled and the market would be less healthy.
A risk premium is the additional return that a risky investment should provide (as compared to a riskless investment, usually a Treasury bond) in order to compensate the investor for taking the risk (Ross et al., 2013). Before an investment is undertaken, the risk premium will be positive; otherwise, why would the individual wish to purchase it? There may be some cases in which the person may want to buy a risky security simply because it is risky, expecting only the intangible thrill but not the tangible gain of increased worth. However, this is unlikely. It is quite possible for the risk premium to be negative after the fact; the expected larger return may not materialize. In that case, the risky investment would return less than the riskless investment.
- Boboc, I. A., & Dinică, M. C. (2013). An Algorithm for Testing the Efficient Market Hypothesis. PloS one, 8(10), e78177.
- Borges, M. R. (2010). Efficient market hypothesis in European stock markets. The European Journal of Finance, 16(7), 711-726.
- Epstein, G., & Crotty, J. (2012). How big is too big? On the social efficiency of the financial sector in the United States. In INET conference, Berlin. Available at www. ineteconomics. org.
- Han, B., & Kumar, A. (2013). Speculative retail trading and asset prices. Journal of Financial and Quantitative Analysis, 1-53.
- Jarrow, R. A., & Larsson, M. (2012). The meaning of market efficiency. Mathematical Finance, 22(1), 1-30.
- Ross, R., Westerfield, R. & Jaffe, J. (2013) Corporate Finance (10th Ed.)
Sewell, M. (2011). History of the efficient market hypothesis. RN, 11(04), 04.
- Open University. (2014). The Efficient Markets Hypothesis. Retrieved from http://www.open.edu