What Is the Efficient Market Hypothesis (EMH)?
Let me explain the Efficient Market Hypothesis, or EMH, directly to you: it's a theory that says share prices always reflect all the information out there, so you can't consistently generate alpha without taking on more risk. Stocks trade at their fair value on exchanges, which means you can't buy undervalued ones or sell overpriced ones to beat the market. The only path to higher returns, according to this, is through riskier investments.
How It Works
You should understand that EMH is a core idea in modern finance, but it's controversial. Supporters say there's no point hunting for undervalued stocks or predicting trends with fundamental or technical analysis because prices already include everything. Random market movements mean your best bet is a low-cost, passive portfolio. In theory, only insider info could give you an edge for outsized returns, but that's not legal or reliable.
EMH and Passive Investing
EMH pushes you toward passive investing, where you buy and hold a low-cost portfolio long-term instead of trying to actively pick winners. Data from Morningstar's studies shows mixed results: in some periods, like 2023-2024, about half of active funds beat passive ones, especially in bonds, but over longer terms like 2009-2019, only 23% did. Generally, you're better off with low-cost index funds or ETFs, as identifying consistently outperforming active managers is tough.
Market Inefficiencies
Markets aren't always efficient, and EMH acknowledges that. Inefficient markets have prices that don't match true value due to things like information gaps, low liquidity, high costs, or human emotions. This can lead to losses or failures. EMH comes in forms: semi-strong says public info is priced in, so analysis won't help much; weak says past prices are reflected, ruling out technical analysis for predictions.
The Bottom Line
In summary, EMH holds that markets are efficient with prices reflecting all info, so stick to passive portfolios for the best results. Critics argue you can beat the market, citing Buffett's success, but research backs EMH overall: passive strategies win for most investors in the long run.
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