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Efficient Market Hypothesis: Strong, Semi-Strong, and Weak

If I were to choose one thing from the academic world of finance that I think more individual investors need to know about, it would be the efficient market hypothesis. The name efficient market hypothesis sounds terribly arcane. But its significance is huge for investors, and (at a basic level) its not very hard to understand.

So what is the efficient market hypothesis (EMH)?

As professor Eugene Fama (the man most often credited as the father of EMH) explains, in an efficient market, the current price [of an investment] should reflect all available informationso prices should change only based on unexpected new information. Its important to note that, as Fama himself has said, the efficient market hypothesis is a model, not a rule. It describes how markets tend to work. It does not dictate how they must work. EMH is typically broken down into three forms (weak, semi-strong, and strong) each with their own implications and varying levels of data to back them up.

Weak Efficient Market Hypothesis

The weak form of EMH says that you cannot predict future stock prices on the basis of past stock prices. Weak-form EMH is a shot aimed directly at technical analysis. If past stock prices dont help to predict future prices, theres no point in looking at them no point in trying to discern patterns in stock charts. From what Ive seen, most academic studies seem to show that weak-form EMH holds up pretty well. (Take, for example, the recent study which tested over 5,000 technical analysis rules and showed them to be unsuccessful at generating abnormally high returns.)

Semi-Strong Efficient Market Hypothesis

The semi-strong form of EMH says that you cannot use any published information to predict future prices. Semi-strong EMH is a shot aimed at fundamental analysis. If all published information is already reflected in a stocks price, then theres nothing to be gained from looking at financial statements or from paying somebody (i.e., a fund manager) to do that for you. Semi-strong EMH has also held up reasonably well. For example, the number of active fund managers who outperform the market has historically been no more than can be easily attributed to pure randomness. Semi-strong EMH does not appear to be ironclad, however, as there have been a small handful of investors (e.g., Peter Lynch, Warren Buffet) whose outperformance is of a sufficient degree that its extremely difficult to explain as just luck. The trick, of course, is that its nearly impossible to identify such an investor in time to profit from it. You must either: Invest with a fund manager after only a few years of outperformance (at which point his/her performance could easily be due to luck), or Wait until the manager has provided enough data so that you can be sure that his performance is due to skill (at which point his fund will be sufficiently large that hell have trouble outperforming in the future).

Strong Efficient Market Hypothesis

The strong form of EMH says that everything that is knowable even unpublished information has already been reflected in present prices. The implication here would be that even if you have some inside information and could legally trade based upon it, you would gain nothing by doing so. The way I see it, strong-form EMH isnt terribly relevant to most individual investors, as its not too often that we have information not available to the institutional investors.

Why You Should Care About EMH

Given the degree to which theyve held up, the implications of weak and semi-strong EMH cannot be overstated. In short, the takeaway is that theres very little evidence indicating that individual investors can do anything better than simply buy & hold a low-cost, diversified portfolio.

Securities Markets - Weak, Semi-Strong and Strong EMH

The Three Basic Forms of the EMH The efficient market hypothesis assumes that markets are efficient. However, the efficient market hypothesis (EMH) can be categorized into three basic levels:

1. Weak-Form EMH The weak-form EMH implies that the market is efficient, reflecting all market information. This hypothesis assumes that the rates of return on the market should be independent; past rates of return have no effect on future rates. Given this assumption, rules such as the ones traders use to buy or sell a stock, are invalid.

2. Semi-Strong EMH The semi-strong form EMH implies that the market is efficient, reflecting all publicly available information. This hypothesis assumes that stocks adjust quickly to absorb new information. The semi-strong form EMH also incorporates the weak-form hypothesis. Given the assumption that stock prices reflect all new available information and investors purchase stocks after this information is released, an investor cannot benefit over and above the market by trading on new information.

3. Strong-Form EMH The strong-form EMH implies that the market is efficient: it reflects all information both public and private, building and incorporating the weak-form EMH and the semi-strong form EMH. Given the assumption that stock prices reflect all information (public as well as private) no investor would be able to profit above the average investor even if he was given new information.

Weak Form Tests The tests of the weak form of the EMH can be categorized as:


Statistical Tests for Independence - In our discussion on the weak-form EMH, we stated that the weak-form EMH assumes that the rates of return on the market are independent. Given that assumption, the tests used to examine the weak form of the EMH test for the independence assumption. Examples of these tests are the autocorrelation tests (returns are not significantly correlated over time) and runs tests (stock price changes are independent over time).


Trading Tests - Another point we discussed regarding the weak-form EMH is that past returns are not indicative of future results, therefore, the rules that traders follow are invalid. An example of a trading test would be the filter rule, which shows that after transaction costs, an investor cannot earn an abnormal return.

Semi-strong Form Tests

Given that the semi-strong form implies that the market is reflective of all publicly available information, the tests of the semi-strong form of the EMH are as follows:


Event Tests - The semi-strong form assumes that the market is reflective of all publicly available information. An event test analyzes the security both before and after an event, such as earnings. The idea behind the event test is that an investor will not be able to reap an above average return by trading on an event.


Regression/Time Series Tests - Remember that a time series forecasts returns based historical data. As a result, an investor should not be able to achieve an abnormal return using this method.

Strong-Form Tests Given that the strong-form implies that the market is reflective of all information, both public and private, the tests for the strong-form center around groups of investors with excess information. These investors are as follows:


Insiders - Insiders to a company, such as senior managers, have access to inside information. SEC regulations forbid insiders for using this information to achieve abnormal returns.


Exchange Specialists - An exchange specialist recalls runs on the orders for a specific equity. It has been found however, that exchange specialists can achieve above average returns with this specific order information.


Analysts - The equity analyst has been an interesting test. It analyzes whether an analyst's opinion can help an investor achieve above average returns. Analysts do typically cause movements in the equities they focus on.


Institutional money managers - Institutional money managers, working for mutual funds, pensions and other types of institutional accounts, have been found to have typically not perform above the overall market benchmark on a consistent basis.