Efficient market hypothesis

Efficient-market hypothesis (EMH) is a theory in financial economics that states that an asset's prices fully reflects all available information. A direct implication is that it is impossible to "beat the market" consistently on a risk-adjusted basis since market prices should only react to new information or changes in discount rates (the latter may be predictable or unpredictable).

The EMH was developed by Professor Eugene Fama who argued that stocks always trade at their fair value, making it impossible for investors to either purchase undervalued stocks or sell stocks for inflated prices. As such, it should be impossible to outperform the overall market through expert stock selection or market timing, and that the only way an investor can possibly obtain higher returns is by chance or by purchasing riskier investments. His 2012 study with Kenneth French confirmed this view, showing that the distribution of abnormal returns of US mutual funds is very similar to what would be expected if no fund managers had any skill—a necessary condition for the EMH to hold.

There are three variants of the hypothesis: "weak," "semi-strong," and "strong" form. The weak form of the EMH claims that prices on traded assets (e.g., , bonds, or property) already reflect all past publicly available information. The semi-strong form of the EMH claims both that prices reflect all publicly available information and that prices instantly change to reflect new public information. The strong form of the EMH additionally claims that prices instantly reflect even hidden "insider" information.

Critics have blamed the belief in rational markets for much of the late-2000s financial crisis. In response, proponents of the hypothesis have stated that market efficiency does not mean not having any uncertainty about the future, that market efficiency is a simplification of the world which may not always hold true, and that the market is practically efficient for investment purposes for most individuals.

Historically, the EMH is preceded by Hayek's (1945) argument that markets are the most effective way of aggregating the pieces of information dispersed amongst individuals within a society. Given the ability to profit from private information, self-interested traders are motivated to acquire and act on their private information. In doing so, traders contribute to more and more efficient market prices. In the competitive limit, market prices reflect all available information and prices can only move in response to news. Thus there is a very close link between EMH and the random walk hypothesis which was discussed in 1863 by Jules Regnault, a French broker. Later another French mathematician, Louis Bachelier, applied probability theory in his 1900 PhD thesis, "The Theory of Speculation." His work was largely ignored until the 1950s when financial economists began making heavy use of probability theory and statistics to model asset prices (in particular, options prices).

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