Efficient Market Hypothesis

Lesson

The Efficient Market Hypothesis (EMH) is an investment theory that states that it is impossible to consistently outperform the market by using any information that is already publicly available. This is because all available information is already reflected in the prices of securities, making it difficult for investors to gain an edge over the market. There are three forms of EMH: weak, semi-strong, and strong, each with varying degrees of efficiency.

Practice Question #1

Which form of the Efficient Market Hypothesis states that all publicly available information is already reflected in stock prices?

A) Weak form

B) Semi-strong form

C) Strong form

D) Random walk theory

Select an option above to see an explanation here.

A) The weak form states that past trading information is already reflected in stock prices. B) The semi-strong form states that all publicly available information is already reflected in stock prices. C) The strong form states that all public and private information is already reflected in stock prices. D) The random walk theory states that stock prices move randomly and unpredictably.

Terms

Efficient Market Hypothesis (EMH):: An investment theory stating that it is impossible to outperform the market using publicly available information consistently.
Weak form EMH:: A form of EMH that states that past trading information is already reflected in stock prices, making it impossible to outperform the market using technical analysis consistently.
Semi-strong form EMH:: A form of EMH that states that all publicly available information is already reflected in stock prices, making it impossible to outperform the market using fundamental analysis consistently.
Strong form EMH:: A form of EMH that states that all information, both public and private, is already reflected in stock prices, making it impossible for anyone to outperform the market consistently.

Practice Question #2

What type of analysis is rendered ineffective by the weak form of the Efficient Market Hypothesis?

A) Technical analysis

B) Fundamental analysis

C) Behavioral analysis

D) Quantitative analysis

Select an option above to see an explanation here.

A) Technical analysis is rendered ineffective by the weak form of EMH, as it relies on past trading information. B) Fundamental analysis is rendered ineffective by the semi-strong form of EMH. C) Behavioral analysis is not directly related to the EMH. D) Quantitative analysis is a broad term encompassing various types of analysis.

Do Not Confuse With

Technical analysis:: A method of evaluating securities by analyzing past market data, such as price and volume.
Fundamental analysis:: A method of evaluating securities by analyzing financial and economic factors, such as earnings and economic indicators.

Practice Question #3

Which of the following is an example of a market anomaly that contradicts the Efficient Market Hypothesis?

A) The January effect

B) The random walk theory

C) The Capital Asset Pricing Model

D) The Modern Portfolio Theory

Select an option above to see an explanation here.

A) The January effect is a market anomaly where stock prices tend to rise in January, contradicting the EMH. B) The random walk theory supports the EMH, stating that stock prices move randomly and unpredictably. C) The Capital Asset Pricing Model is used to determine an asset's expected return, not a market anomaly. D) The Modern Portfolio Theory is a theory that focuses on the relationship between risk and return in a portfolio, not a market anomaly.

Real-World Example

In 2013, Tesla Motors' stock price increased by over 300% in just six months, despite the company's financials not justifying such a rapid rise. This could be seen as evidence against the EMH, as the stock price was driven by investor sentiment rather than fundamental information.