BAJAJ BROKING
August 30, 2024
5 mins read
Proposed by the American economist Eugene Fama, the efficient market hypothesis suggests that investors cannot beat the market consistently over a long period of time. As per this hypothesis, all the information about a security is already factored into its price. Hence, investors cannot outshine each other by either analysing it better or timing it better. This theory assumes that there are no transaction costs in the market, investors are always rational, and information does not come at a cost. While these assumptions hold true to a large extent in real life, they do not always hold true.
The efficient market hypothesis (EMH) is one of the most popular theories of the financial market. As per EMH, a security's price reflects all sorts of information available about it. In other words, all securities always trade at their fair value in the market. Hence, the market is always efficient. Therefore, the market does not have under-valued or over-valued stocks, as all stocks trade at their fair value. This hypothesis was developed by American economist Eugene Fama. In simple words, the efficient market hypothesis suggests that investors cannot generate higher returns than the market. The only way they can do that is by buying securities with a considerably higher risk. Having learnt what the efficient market hypothesis is, let’s delve deeper into this topic.
There are three forms of this hypothesis:
Weak Form: As per this, the stock price of a stock today reflects its past prices perfectly. Hence, technical analysis cannot help people buy or sell a stock. However, fundamental analysis (which is based on a company's financials) can help people find over and under valued stocks. Using which, investors can make a higher return than the market.
Semi-Strong Form: This approach argues that a stock's price reflects all information available about it publicly. Hence, neither technical nor fundamental analysis can help investors beat the market. The only way to earn a higher return than the market is by having access to information that is not publicly available.
Strong Form: As per this version, all sorts of information, whether publicly available or not publicly available, is factored into stock prices. Hence, investors can never earn a higher return than the market.
The efficient market hypothesis is based on certain assumptions. First, transaction costs don’t exist in the market. If these costs exist, then even if two investors have exactly the same information, they may not generate the same returns. Second, information does not have a cost. If not for this, an investor may pay more for certain information than his peers and hence generate less returns than others. Third, all investors have exactly the same expectations from a security. Fourth, investors are totally rational.
We only have to look at the assumptions behind this hypothesis to understand the arguments for and against EMH. Most assumptions behind EMH hold true to an extent but not entirely. Hence, those who argue for it cite the extent to which these assumptions hold true in the real world, while those who argue against it cite instances when these assumptions don’t hold.
For example, this hypothesis proposes that all investors have exactly the same information. Several trading scandals have happened worldwide in the last few decades, which show that certain traders knew more about a stock than most other traders. Hence, this assumption is true but only to an extent.
Similarly, EMH assumes that transaction costs don’t exist in the market. Over the years, transaction costs have come down; however, they still exist. This assumption, too, holds but only to an extent.
This hypothesis rests on the assumption that no one can beat the market consistently over a long period. Hence, it suggests that investors should hold a diversified portfolio that mirrors the composition of the market. Therefore, as per this theory, investors can invest in an index fund because they are unlikely to beat the market by actively managing their own investments. Hence, they should adopt a passive approach by investing in an index fund that has the same composition as the stock market.
While the efficient market hypothesis has its merits, it also has its limitations. For example, it assumes that all investors are rational. In reality, all investors cannot be rational all the time. When the stock market moves up or down significantly, many investors make a decision to buy or sell a stock with a huge trading volume purely based on their emotions. Besides, this hypothesis is unable to explain how certain anomalies happen in the market. Let’s take the case of the January effect, as per which stocks tend to perform better in January than in other months. EMH cannot explain this effect.
This hypothesis has several practical applications. You can apply it by investing in an index fund or having a passive strategy. You can invest in an index fund that holds stocks in the same proportion as an index like Nifty. As a result, you don’t have to worry about picking stocks yourself and yet you earn the returns generated by the fund, which mirrors the market. EMF has a practical application for regulators, too. This hypothesis clearly shows how markets function with transparency and absolute information symmetry. Hence, regulators can use its insights to formulate policies that ensure the highest level of transparency in the market.
As per the efficient market hypothesis, no one can beat the market consistently over a long period. Hence, people are advised to invest in a well-diversified index fund that has the same composition of stocks as an index like Nifty. This is a passive approach towards investment because it allows people to invest in an index fund, rather than actively selecting stocks. On the other hand, active management requires investors to actively select stocks themselves to purchase or sell.
If you are just beginning to trade and have just opened a new demat account, it’s not difficult to learn the meaning of the efficient market hypothesis. However, applying it in real life can be a bit tricky. At times when the market swings crazily, some investors may think that this hypothesis doesn’t apply. However, it does apply to a large extent over a long period. In other words, it’s extremely difficult for anyone to earn a higher return than the market over the long run without taking a considerably higher risk than the market.
Disclaimer: Investments in the securities market are subject to market risk, read all related documents carefully before investing.
This content is for educational purposes only. Securities quoted are exemplary and not recommendatory.
For All Disclaimers Click Here: https://bit.ly/3Tcsfuc
Share this article: 
7th Pay Commission Leave Rules & Holidays in India
11 Dec, 2024 | 5 Min. read
Wipro Ltd
11 Dec, 2024 | 7 Min. read
Aditya Birla Group
11 Dec, 2024 | 10 Min. read
What is the Lock-in Period in IPO
11 Dec, 2024 | 6 Min. read
Textile Sector in India
11 Dec, 2024 | 11 Min. read
Step-by-Step Guide to Accessing Your Income Tax Assessment Order Online
11 Dec, 2024 | 3 Min. read
IPO vs FPO vs OFS: Key Differences in How Companies Raise Capital
11 Dec, 2024 | 8 Min. read
Gold Price in India - Gold Prices Edge Higher as Futures Hit $2,654.50
11 Dec, 2024 | 39 Min. read
Indian Overseas Bank Secures ₹1,359 Crore Income Tax Refund for AY 2015-16
11 Dec, 2024 | 2 Min. read
HG Infra Secures ₹899 Crore NH-227B Road Upgrade Project in UP
11 Dec, 2024 | 2 Min. read
NTPC Green Energy Secures 500 MW Solar Project with 250 MW ESS from SECI
11 Dec, 2024 | 2 Min. read
Awfis Space ₹583 Crore Block Deal Launches at ₹680 Floor Price
11 Dec, 2024 | 2 Min. read
RBI Launches ULI: Transforming Loan Access
August 27, 2024 | 4 Min. read
Textile Sector in India
September 20, 2024 | 5 Min. read
List of IPOs with DRHPs Filed
November 30, 2023 | 3 Min. read
Aditya Birla Group
September 28, 2023 | 10 Min. read
Bajaj Housing Finance Ltd IPO: Things Smart Investors Need to Know
September 05, 2024 | 4 Min. read
Budget Stock Ideas 2024-2025 | Stocks to Buy Today
July 24, 2024 | 4 Min. read
IPO Eligibility Criteria : Full Details
March 15, 2024 | 6 Min. read
What Is the Lock-In Period in IPOs?
October 18, 2023 | 6 Min. read
Godfrey Phillips Announces 2:1 Bonus Shares
September 16, 2024 | 7 Min. read
Jindal Group- A Comprehensive Analysis
September 27, 2024 | 7 Min. read
This hypothesis proposes that the market is always efficient. Hence, no one can generate a better return than the market consistently over a long period.
There are three forms of this hypothesis: weak, semi-strong, and strong.
As this hypothesis proposes that you can’t generate a higher return than the market, it suggests that you can invest in an index fund, which mirrors the market. Hence, it advocates the passive approach of investment.
This hypothesis assumes that all investors are always rational. This is not true. Often investors take a decision in the grip of an emotion, particularly when the market is swinging crazily.
Investors can apply this hypothesis by not actively buying and selling securities. Instead, they can adopt the passive approach by investing in an index fund that mirrors an index in terms of stock composition.
Take the case of the January effect, wherein stocks usually provide better returns in the month of January than in other months. The efficient market hypothesis cannot explain this phenomenon.
As per behavioural finance, investors are not always rational and hence the market cannot always be efficient. Behavioural finance suggests that the cognitive biases of investors often result in irrational decisions.
No Result Found
Level up your stock market experience: Download the Bajaj Broking App for effortless investing and trading
TRENDING CALCULATORS AND STOCKS ON BAJAJ BROKING
POPULAR STOCKS: Tata Motors Share Price Infosys Share Price IRFC Share Price SBI Card Share Price Cipla Share Price NBCC Share Price IDFC First Bank Share Price IRCTC Share Price PNB Share Price Zomato Share Price Vodafone Idea Share Price Axis Bank Share Price JSW Steel Share Price Bandhan Bank Share Price SBI Share Price Tata Steel Share Price ONGC Share Price Ashok Leyland Share Price Paytm Share Price Subex Share Price DLF Share Price Reliance Share Price HDFC Bank Share Price Suzlon Share Price IOC Share Price HUL Share Price Asian Paints Share Price Bank Of Baroda Share Price ITC Share Price TCS Share Price HFCL Share Price Icici Bank Share Price Tata Chemicals Share Price CDSI Share Price MRF Share Price Tata Power Share Price Adani Green share price BPCL Share Price Vedanta Share Price Dmart Share Price Hindalco Share Price LIC Share Price SAIL Share Price Adani Port Share Price IEX Share Price Nalco Share Price L&T Share Price Adani Power Share Price BHEL Share Price Bajaj Finance Share Price Canara Bank Share Price Indusind Bank Share Price Gail Share Price Yes Bank Share Price Wipro Share Price Happiest Minds Share Price Coal India Share Price Maruti Share Price Reliance Power Share Price
INDIAN INDICES: Nifty 50 Share Price SENSEX Share Price Nifty Next 50 Share Price BSE100 Share Price Nifty Bank Share Price LRGCAP Share Price Nifty 100 Share Price MIDCAP Share Price Nifty 200 Share Price SMLCAP Share Price Nifty 500 Share Price BSE500 Share Price Nifty Midcap 50 Share Price ALLCAP Share Price NIFTY SMLCAP 50 Share Price BSE200 Share Price India VIX Share Price BSEIPO Share Price
