Efficient Market Hypothesis (EMH) : Definition, Types & Example

  1. Understand

Efficient market hypothesis (EMH) is an investment theory developed by Eugene Famain 1965, which states that all information (regarding company) fully reflects in its share price and its shares always trade at a fair value, so there is no way to earn profit by purchasing undervalued shares and sell them at premium, the only way to earn profit is by investing in risky shares.The key reason behind the theory is that stock markets have intense competition among investors who made strong efforts to find out undervalued stocks, naturally as the completion increase, the opportunity of undervalued stock becomes smaller and smaller.

Since its proposition, the theory has been considered controversial and often disputed however its supporters still believe that there is no need for technical analysis or fundamental analysis to predict market trends.

Example

Suppose a company ABC is a mutual fund company with a total fund of $ 10 million invested in a stock exchange, In order to get a return on fund [Investment], management of the company uses forecasting and valuation techniques to aid in decision making. At the end of the year, the company makes 1% gain of $100,000 from the investment after excluding transaction cost. According to EMH, there is no need to have forecasting and valuation techniques rather risky stocks should be considered for gain in investment.

Three Types (Versions) of Efficient Market Hypothesis (EMH)

The theory is based on “all information available”, and researchers have categorized a different kind of information that influences stocks prices:

Strong Form

The Strong form of efficient market hypothesis suggests that current value or price of a company’s share fully incorporates all (internal and external) existing information available.

Semi-Strong Form

According to the semi-strong form of efficient market hypothesis, a company’s share price incorporates all external existing information, which may include data published in recent financial statements, past prices trends, dividend announcements and public information regarding future expansion plans.

Weak Form

This form of efficient market hypothesis states that a company’s share price incorporates only past information.

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