There are many financial theories that try to explain the formation of asset prices in the capital market. Among them, a much debated is the efficient market hypothesis, or EMH. There are experts and academics who believe in the existence of an efficient market, as there are those who oppose it. But what does that mean?
What is efficient market hypothesis?
The Efficient market hypothesis is an investment theory that justifies that market prices always reflect all existing information. Therefore, there are no cheap or expensive stocks, and obtaining returns above the market average in the long run is not possible. The origin of this hypothesis was formulated in the 1960s by the American economist Eugene Fama. And since then, it is one of the pillars of financial theory, known as efficient market hypothesis Fama theory.
What are the efficiencies of EMH?
The hypothesis has three distinct levels of efficiency:
Weak efficiency: Maintains that the market is efficient in reflecting all available public information. Market returns are independent. Therefore, past returns do not help to predict future returns.
Semi-strong efficiency: Encompasses the weak hypothesis, and suggests that new information is absorbed into the market instantly. Thus, investors do not achieve results above the market with known information.
Strong efficiency: Encompasses the other assumptions, and maintains that asset prices instantly reflect all types of information. Be it public or private. Thus, no investor would achieve returns above the market even if he obtained new information.
Implications of an efficient market
Those who believe that markets are efficient are advocates of passive investments. In other words, to invest in investment funds that monitors the profitability of a benchmark. This is because in this hypothesis of price formation there would not be what the market calls Alpha, which means achieving returns above the market through analysis. In fact, over time, all managers, no matter how good they are, would converge on average to have the same profitability in the market.
Conclusion: Know the best efficient market theory
Thus, investing in an active fund, which does asset analysis to get Alpha, would have the same result and would be more costly. Therefore, over time, passive funds would be more advantageous because they have lower costs to the investor. Therefore, investing in active funds from good managers is the best way to achieve higher returns. Thus, the advantages of efficient market hypothesis is one of the biggest financial discussions today.