In today’s digital markets, news and data spread quickly. When new information becomes available, it can affect security prices almost immediately. That raises a practical question for investors: if prices adjust so fast, does research still help you make better investment decisions?
Before buying or selling, investors often review metrics such as:
Even if those metrics look favorable, does that automatically mean the investment is a good buy? What if other investors have already seen the same information, acted on it, and pushed the price to a level that already reflects it (in other words, it’s already “baked into” the market price)?
Investors who believe available information is already incorporated into a security’s market price are proponents of the efficient market hypothesis (EMH). EMH states that available market data and information about a security are reflected in its current market price. Because information travels quickly, it becomes priced into the security nearly instantaneously.
If EMH is true, then research has limited value for predicting future price movements. You might conclude - based on your own analysis - that a security is attractive, but EMH argues that your conclusion is based on information the market has already processed. Any price impact from that information would have occurred in the past, not in the future.
If you accept EMH, you’d typically avoid trying to pick individual “winners” and instead focus on passive investing strategies. The idea is to capture the performance of broad market segments rather than selecting individual securities based on characteristics that are already reflected in price. This approach can also help you avoid higher expense ratios charged by actively managed funds, which pay analysts to perform research that EMH supporters view as ineffective.
There are three versions of EMH to be aware of:
Strong form EMH states that all public and private information is reflected in the market prices of securities. Under this view, even non-public inside information* wouldn’t reliably help an investor earn excess returns.
This can feel counterintuitive because there is an undeniable history of investors making significant returns or avoiding large losses by illegally using inside information. Strong form EMH doesn’t necessarily deny that history. Instead, it argues that even private information may not be consistently useful because unexpected events can overwhelm it.
*Trading on material, non-public information, also known as inside information, is explicitly illegal. The specifics related to this concept are discussed in a future chapter.
For example, suppose an executive at an oil company knows an upcoming earnings report will show profitability growing much more than expected. Expecting the stock price to rise when the report becomes public, the executive buys a large amount of company stock just before the release (illegally).
A few days before the earnings report is released, an explosion occurs at one of the company’s rigs, causing a catastrophic environmental disaster. Cleanup costs and legal liabilities lead to billions of dollars in losses. The stock price drops sharply, despite the favorable earnings report.
In this scenario, even private insider information didn’t lead to a profit. Strong form EMH argues that outcomes like this - where new, unpredictable events dominate - are more common than they may appear.
Semi-strong form EMH states that all public information is reflected in the market prices of securities. This is a step down from strong form EMH.
Semi-strong EMH argues that non-public information can consistently predict future market movements. Under this view, situations like the oil company example can happen, but they’re considered infrequent.
Weak form EMH states that most public information is reflected in the market prices of securities. Like semi-strong EMH, weak form EMH also argues private information can consistently predict future market movements. However, it adds another source of potential predictability: complex fundamental analysis may provide insights into future supply and demand.
In the fundamental analysis chapter, we discussed the basics of balance sheets and income statements. The key word is “basics.” Many analysts spend years developing the skills needed to interpret the details in these financial statements.
For example, here’s Nike’s 2021 annual report, which includes 109 pages of information about the company’s operations and finances. Can you analyze that report well enough to estimate the value of the company’s stock?
If not, you’re in the majority of investors who rely on the expertise and analysis of others. This is the core argument behind weak form EMH: if only a small portion of investors can correctly interpret complex fundamental information, then those investors may be able to predict market price movements more consistently than the general public.
Proponents of EMH believe future market movements are random and unpredictable. How strongly they believe this depends on which form of EMH they accept:
Strong form EMH
Semi-strong form EMH
Weak form EMH
No matter which form of EMH you choose, technical analysis is not believed to consistently predict market movements. As discussed in a previous chapter, technical analysis assumes market patterns repeat. That conflicts with EMH, which treats market fluctuations as random and unpredictable.
Some investors describe EMH’s conclusion using a related theory: the random walk hypothesis. The random walk hypothesis states that market dynamics are consistently unpredictable, so attempts to evaluate an investment using available information are useless.
The more an investor believes in EMH or the random walk hypothesis, the more likely they are to use passive investment strategies. The reverse is also true: the less an investor believes in EMH or the random walk hypothesis, the more likely they are to use active investment strategies.
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