Tag Archives: EMH

Efficient Market Hypothesis (EMH) and you

Per Wikipedia (link), the efficient market hypothesis (EMH) is defined as:

..the efficient-market hypothesis (EMH) asserts that financial markets are “informationally efficient”. That is, one cannot consistently achieve returns in excess of average market returns on a risk-adjusted basis, given the information available at the time the investment is made.

There are three major versions of the hypothesis: “weak”, “semi-strong”, and “strong”. The weak-form EMH claims that prices on traded assets (e.g.,stocks, bonds, or property) already reflect all past publicly available information. The semi-strong-form EMH claims both that prices reflect all publicly available information and that prices instantly change to reflect new public information. The strong-form EMH additionally claims that prices instantly reflect even hidden or “insider” information. There is evidence for and against the weak-form and semi-strong-form EMHs, while there is evidence against strong-form EMH.

As mentioned earlier in our posts here and here that the markets are not efficient, actually, they are highly inefficient. The market fails to adjust the stock price to the correct price. Now that comes with a corollary, that individual investors CAN find the right investment, and achieve consistent higher returns that the market.

However to achieve higher returns than the market, one needs to grasp the long-term horizon and focus away from the short-term market risk, aka volatility in the stock prices. A prudent investor understands that this notion of risk fades away in the long-term as the only risk that does matter in the long-term is the soundness of the business and operations you are investing in.

Another corollary from inefficient market hypothesis is that an investor just cannot pick random stocks from the index and achieve the average return of the stock market, and it would be rather foolish to take such approach. Common sense investing necessitates that the investor must investigate the operations and soundness of the business by thoroughly analyzing the balance sheet and the income statement.

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