Understanding the Efficient Market Hypothesis (EMH)
Nov 22, 2025
The Efficient Market Hypothesis sits at the centre of modern finance like a smug referee, insisting the game is fair because prices already “know” everything. At its simplest, the EMH claims that financial markets are informationally efficient, meaning asset prices fully reflect all available information. If that is true, your stock-picking genius is not ga enius at all. It is random variance with a good marketing department.
Eugene Fama, who formalised the EMH in the 1960s, reduced it to one line: security prices fully reflect all available information. That sounds simple. The fight starts when you ask what “fully” and “information” actually mean in live markets filled with panic, greed, and latency. Hence, the three flavours of EMH, each one bolder than the last.
- The weak form of the EMH says you cannot predict future prices from past prices. If it holds, pure chart-worship should not give you consistent alpha.
- The semi-strong form of the EMH says that all publicly available information is already reflected in prices. If that is true, fundamental analysis might still be fun, but it will not reliably beat the index after costs.
- Strong form EMH goes full absolutist, claiming that all information, public and private, is reflected in prices. Under that version, even insider trading would not help you. At that point, the only rational strategy is humility and maybe an index fund.
So which of these “defines” EMH? Technically, all three. They are stacked claims on the same idea, from “markets are pretty quick” to “markets are an all-seeing oracle.” Reality tends to sit closer to the first two, while strong-form EMH functions more as a thought experiment than a description of the circus you actually trade.
The obsession with efficiency has older roots than most textbooks admit. Around 1750 BC, the Code of Hammurabi laid out rules on loans, interest caps, and penalties for abusive creditors in Babylon. That was not EMH, but it was an early acknowledgement that markets need structure because humans will push any advantage until something breaks.
By the 16th century, Girolamo Cardano was wrestling with probability in gambling, laying the groundwork for thinking about randomness long before quants had spreadsheets. His bleak insight, that the greatest edge in gambling is often not to play at all, lands uncomfortably close to the harsher interpretations of strong-form EMH. If prices really do reflect everything that matters, then the market is not a puzzle to solve. It is a machine that lets you rent exposure to human progress while reminding you that your personal brilliance is strictly optional.
EMH and Technical Analysis
The weak form of EMH poses a direct challenge to technical analysis, which attempts to predict future price movements based on historical data. If markets are efficient even in their weak form, such predictions should be impossible.
However, many traders continue to use technical analysis. Jesse Livermore, a renowned stock trader of the early 20th century, famously said, “There is nothing new in Wall Street. There can’t be because speculation is as old as the hills. Whatever happens in the stock market today has happened before and will happen again.” This view suggests that patterns do repeat, contradicting the weak form of EMH.
EMH and Fundamental Analysis
The semi-strong form of EMH challenges the effectiveness of fundamental analysis. If all public information is already reflected in stock prices, then analyzing financial statements and economic data should not provide an advantage.
Benjamin Graham, often considered the father of value investing, argued against this view. In the mid-20th century, he stated, “In the short run, the market is a voting machine, but in the long run, it is a weighing machine.” This suggests that while markets may be efficient in incorporating information, they can still misprice assets in the short term, creating opportunities for astute investors.
EMH and Insider Information
The strong form of EMH is perhaps the most controversial, as it suggests that even insider information is quickly incorporated into market prices. This form has significant implications for market regulation and the concept of insider trading.
In the late 20th century, Fischer Black, co-author of the Black-Scholes options pricing model, offered a nuanced view: “Markets look a lot less efficient from the banks of the Hudson than from the banks of the Charles.” This suggests that market efficiency may vary depending on one’s perspective and the specific market in question.
Mass Psychology and EMH
The field of behavioural finance has challenged some aspects of the EMH by highlighting how psychological factors can create market inefficiencies. Robert Shiller, an economist known for his work on market volatility, argued in the late 20th and early 21st centuries that social dynamics can create speculative bubbles inconsistent with the EMH.
Shiller stated, “The stock market has not come down to historical levels: the price-earnings ratio as I define it in this book is still, at recent prices, in the mid-20s, far higher than the historical average of 14 or 15.” This observation suggests that markets may not always be as efficient as EMH would predict.
Cognitive Biases and Market Efficiency
Cognitive biases can lead investors to make irrational decisions, potentially creating market inefficiencies. For example, confirmation bias might cause an investor to seek out information that supports their existing beliefs about a stock, ignoring contradictory evidence.
Daniel Kahneman, a psychologist who won the Nobel Prize in Economics for his work on decision-making under uncertainty, noted in the early 21st century, “A reliable way to make people believe in falsehoods is frequent repetition because familiarity is not easily distinguished from truth.” This insight highlights how cognitive biases can create persistent market inefficiencies, challenging the strong form of EMH.
Practical Implications of EMH
The implications of EMH for investors and market participants are significant. If markets are truly efficient, then active investment strategies should not consistently outperform passive, index-based approaches.
John Bogle, founder of Vanguard and pioneer of index investing, capitalised on this idea. He stated in the late 20th century, “Don’t look for the needle in the haystack. Just buy the haystack!” This approach aligns with the semi-strong form of EMH, suggesting that trying to beat the market through stock selection is futile.
EMH and Market Anomalies
Despite the logical appeal of EMH, researchers have identified numerous market anomalies that seem to contradict its principles. These include the January effect, the size effect, and the value premium.
For example, the value premium suggests that stocks with low price-to-book ratios tend to outperform those with high ratios. This anomaly was famously exploited by Benjamin Graham and later by his student Warren Buffett. Buffett once quipped, “I’d be a bum on the street with a tin cup if the markets were always efficient.”
EMH in Different Market Conditions
The degree of market efficiency may vary depending on market conditions. During periods of crisis or extreme volatility, markets may become less efficient as fear and uncertainty dominate decision-making.
George Soros, known for his theory of reflexivity, argued in the late 20th century that market participants’ biased views can influence the fundamentals they are trying to reflect, creating a feedback loop that leads to market inefficiencies. He stated, “Markets are constantly in a state of uncertainty and flux, and money is made by discounting the obvious and betting on the unexpected.”
The Future of EMH
As financial markets continue to evolve, so too does our understanding of market efficiency. The rise of high-frequency trading, artificial intelligence, and big data analytics may increase market efficiency in some ways while potentially creating new forms of inefficiency in others.
Ray Dalio, founder of Bridgewater Associates, offered a balanced view in the early 21st century: “To make money in the markets, you have to think independently and be humble.” This suggests that while markets may be largely efficient, opportunities for skilled investors still exist.
Conclusion
Which of these defines the efficient market hypothesis (EMH)? The answer is not straightforward. While the three forms of EMH provide a framework for understanding market efficiency, the reality is complex and nuanced. Markets may exhibit varying degrees of efficiency at different times and in other contexts.
The ongoing debate surrounding EMH has enriched our understanding of financial markets and investor behaviour. From the ancient laws of Babylon to the latest research in behavioural finance, thinkers throughout history have grappled with questions of market fairness and efficiency.
As we continue to study and participate in financial markets, it’s crucial to remember that efficiency is not an all-or-nothing proposition. Markets may be mostly efficient most of the time, but inefficiencies can and do occur. Understanding EMH and its implications can help investors make more informed decisions, whether they pursue active or passive strategies.
Ultimately, the efficient market hypothesis remains a powerful tool for understanding market behaviour, even as we continue to refine and challenge its assumptions. As we navigate the complex world of investing, keeping an open mind and continuously learning from both historical wisdom and new research will be key to success.
