What is the Efficient Market Hypothesis (EMH)?

//What is the Efficient Market Hypothesis (EMH)?
What is the Efficient Market Hypothesis (EMH)? 2017-10-04T07:03:05+00:00

Definition: The efficient market hypothesis (EMH) is an investment theory launched by Eugene Fama, which holds that investors, who buy securities at efficient prices, should be provided with accurate information and should receive a rate of return that implicitly includes the perceived risk of the security.

What Does Efficient Market Hypothesis Mean?

What is the definition of efficient market hypothesis? The intrinsic value of security is the present value of the expected cash flows that the investment will generate in the future. The market reflects all newly available information in the market price so investors can accurately forecast the expected future value.

The term “new information” implies information that could not be predicted, because, in this case, it would have been integrated into the market price. In this aspect, securities trade at their fair value protecting investors from buying undervalued stocks or selling overvalued stocks. On the other hand, the only possible way to outperform an efficient market is to accept a higher level of investment risk.

Let’s look at an example.

Example

Peter holds 850 shares of a technology company that currently trade at $125.36 per share. His best friend, who is an insider in the company, informs Peter that the stock price will decline over the next days because the company has failed in a project.

Peter does not believe his friend and holds all his shares. A week later, the technology company announces the failure of the deal, and the stock price starts declining sharply, dropping to $105.12 in a couple of days.

The market is efficient and adjusts immediately to the newly available information – in this case, the company’s announcement about the failed deal. To realize a gross gain, Peter should have sold some of his shares at $125.36 per share as soon as the market adjusted to the newly available information. Instead, he held all his shares, thus losing money.

If Peter had sold 400 shares at $125.36 per share, he would realize a gross gain of $50,144. Now that he held all his 850 shares, his loss is 850 x $125.36 – 850 x $105.12 = $106,556 – $89,352 = $17,204.

Summary Definition

Define Efficient Market Hypothesis: Efficient market theory means a that investors should earn a return on their investments according to their perceived risk at the time of investment.