Implications of the Efficient Market Hypothesis

Implications of the Efficient Market Hypothesis

            The Efficient Market Hypothesis (EMH) is a basic fundamental theory that holds that it is impossible to outperform the market either through technical analysis, market timing, or by purchasing undervalued opportunities or selling overpriced holdings.

            This is based on the belief that all relevant information or news is already shared through the market and that all rational information is already reflected in the true price of a stock.  Therefore the only way to possibly outperform the market is by pure chance or by purchasing riskier investments that succeed.

            What EMH means for investors is that ‘expert’ stock brokers are a myth and that they have had success through luck or through a risky portfolio.  It also means that the price of a stock reflects all the relevant information and that it is a fair value at the time.

            On the other hand, opponents to EMH point to investing legends such as Warren Buffett who has consistently outperformed the market for a long period of time.  The EMH cannot also account for stock market crashes, such as the famous 1987 Dow Jones Industrial Average fell over 20% in a single day (EMH).  According to the EMH an event such as this would be literally impossible because the true prices of the stocks would not be subject to such massive deviation and volatility.

            In actuality, for both investors in the U.S. and abroad, the EMH should be used as a guiding principle upon which to build your portfolio, however it should not be the sole basis of your investing philosophy, especially considering the current global economic crisis.

Works Cited

Efficient Market Hypothesis. Investopedia. Jan. 21, 2008. http://www.investopedia.com/terms/e/efficientmarkethypothesis.asp