Efficient Market Hypothesis (EMH)
Overview
The Efficient Market Hypothesis (Fama, 1970) posits that asset prices fully reflect available information, making it impossible to consistently earn abnormal returns. EMH is organized into three forms — weak, semi-strong, and strong — each defined by the information set reflected in prices.
When to Use
- Evaluating whether a trading strategy exploits genuine inefficiency
- Designing event studies (semi-strong form test)
- Assessing if active management adds value over passive indexing
- Debating the validity of technical or fundamental analysis
When NOT to Use
- As justification to ignore all market anomalies without investigation
- When markets are clearly illiquid or informationally segmented
- For normative claims — EMH describes price behavior, not what prices "should" be
Assumptions
IRON LAW: In an efficient market, prices reflect available information —
beating the market consistently requires either superior information
or accepting more risk. No free lunch.Key assumptions:
- Large number of rational, profit-maximizing participants
- Information is costless and available simultaneously to all participants
- Transaction costs do not prevent trading on information
- Investors react quickly and unbiasedly to new information
Methodology
Step 1 — Identify the Information Set
- Weak form: past prices and trading volume only
- Semi-strong form: all publicly available information
- Strong form: all information including private/insider information
Step 2 — Determine the Testable Implication
| Form | Information Reflected | Implication |
|---|---|---|
| Weak | Historical prices | Technical analysis cannot earn excess returns |
| Semi-strong | All public info | Fundamental analysis cannot earn excess returns |
| Strong | All info (public + private) | Even insiders cannot earn excess returns |
Step 3 — Select Appropriate Test
- Weak: autocorrelation tests, runs tests, filter rules
- Semi-strong: event studies (abnormal returns around announcements)
- Strong: insider trading profitability studies
Step 4 — Interpret Results with Joint-Hypothesis Awareness
Any test of efficiency is simultaneously a test of the asset pricing model used to define "abnormal" return.
Output Format
## EMH Assessment: [Market / Strategy]
### Efficiency Form Tested
- Form: [weak / semi-strong / strong]
- Information set: [description]
### Evidence
| Test | Result | Supports Efficiency? |
|------|--------|---------------------|
| [test name] | [finding] | [Yes/No/Ambiguous] |
### Known Anomalies in This Context
- [List relevant anomalies and their current status]
### Conclusion
- [Efficiency assessment with caveats]
- [Joint-hypothesis caveat]Gotchas
- Joint-hypothesis problem: you cannot test efficiency without assuming an equilibrium model
- Grossman-Stiglitz paradox (1980): if markets are perfectly efficient, no one has incentive to gather information
- Anomalies (momentum, value, size) persist but may reflect risk or data mining
- EMH does not claim prices are always "correct" — only that mispricings are not systematically exploitable
- Market efficiency varies by market segment; large-cap equities are more efficient than micro-caps
- Behavioral finance provides systematic counterexamples but does not necessarily invalidate EMH
References
- Fama, E. (1970). Efficient capital markets: a review of theory and empirical work. *Journal of Finance*, 25(2), 383-417.
- Grossman, S. & Stiglitz, J. (1980). On the impossibility of informationally efficient markets. *American Economic Review*, 70(3), 393-408.
- Malkiel, B. (2003). The efficient market hypothesis and its critics. *Journal of Economic Perspectives*, 17(1), 59-82.