The efficient market theory, or efficient market hypothesis (EMH), says that a stock’s price should represent its true value at any given time and that markets rapidly adjust stock prices to reflect new information, such as financial news. The hypothesis has three variations that describe the degree to which different levels of information affect stock values. Those who believe the EMH believe that the market’s efficiency prevents an investor from outperforming the market by picking individual stocks.
The first level of the EMH, the weak-form EMH, says that a stock’s value fully reflects all past price information. According to this level of the hypothesis, you cannot predict future stock prices based on a stock’s past price trends. For example, if a stock’s price falls 30 percent, you cannot accurately predict whether it will continue to fall or whether it will rebound, based on the weak-form EMH. Its future price has no relation to its recent decline, which is already reflected in its current value.
The semi-strong form of the EMH suggests that stock values reflect all publicly available information, such as economic news, as well as past prices. This form of the hypothesis suggests that an investor cannot gain an advantage using information that is already publicly available. For example, if a company announces a quarterly profit that is greater than what the market expected, its stock would rise immediately to reflect the new information. An investor could not use the information to outperform the market once the information is available.
The strong form of the EMH says that stock prices reflect all private information as well as the information from the weak and semi-strong forms of the EMH. Private information is that which is available only to company insiders, such as executives. For example, assume a company employee knows inside information that could increase the company’s stock price when made public. According to the strong-form EMH, the stock price would already reflect this information, which would prevent the employee from profiting by trading the company’s stock.
Not all investors believe the three forms of the EMH. There are instances in which investors outperform the market using past prices and public information, but stock values generally reflect these levels of information described in the weak and semi-strong forms of the EMH. The strong form, however, is less accurate. Inside information about a company is often not reflected in its stock price. Company insiders with this information have an unfair advantage over other investors, which is why U.S. laws prohibit insider trading.
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