Efficient Market Hypothesis is an investment theory that states all relevant information at a given time of a particular security is already reflected in it’s price.
The hypothesis is thought to have been derived from the “Random Walk Hypothesis” which states that stock prices are a random walk and can’t be predicted.
Thus, it is impossible to generate returns higher than the market because all current and relevant information is already reflected in the share price. There are three forms Efficient Market Hypothesis:
- Weak Form Efficient Market
- Semi-Strong Efficient Market
- Strong Form Efficient Market
Weak Form Efficiency
Weak form efficiency states that all past market data, prices, news releases are reflected in the current share price. Technical analysis will not determine the future price of the security and no pattern exist. In a weak form of market efficiency, only fundamental analysis and non public information can help you earn an excess return.
Example of Weak Form Efficiency
Mike started working at McDonald’s. He has been studying more about investments and stocks but has no prior experience. He notice that McDonald’s shares rise on Monday and drop on Friday. One Friday, he purchased 50 shares of McDonald’s stock for $20 per share hoping to sell them next week on a Monday. When the market opened on Monday, McDonald’s shares declined 12%.
In this situation, Mike was trying to analyze past price patterns data in order to earn excess return. However, this was a weak form market efficiency.
Semi-Strong Efficiency
Semi strong form efficient states that the current value of the security is based on all publicly available information. This includes financial reports, accounting statements, historical prices, volume information, etc. Semi-strong market efficiency states that fundamental analysis cannot help predict future price movements and only non public information will allow investors to generate excess return. Semi-strong efficiency encompasses weak form efficiency.
Example of Semi-Strong Form Efficiency
An example of a semi-strong form market efficiency would be when current employment job data is released and the market would act accordingly and adjust as the information is absorbed. If the job data is positive, then markets should move up.
Strong Form Efficiency
In a strong form efficient market, all information whether publicly available or private is fully reflected in a price of a security. Even insiders of public companies are not able to produce excess return. This is the most extreme form of market efficiency and most studies have found that markets are not efficient in this sense.
To conclude, efficient market hypothesis states that all relevant information are already included in the price of a security. There are many different types of forms that the Efficient Market Hypothesis theory states. Which one do you believe?
