What is Efficient Market Hypothesis (EMH)?

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The Efficient Market Hypothesis (EMH), alternatively known as the efficient market theory, is a state in financial economics where the share prices reflect all information and consistent alpha generation is impossible. It’s simply a direct implication that it is impossible to “beat the market consistently on a risk-adjusted basis. More So when the market price should only react to new information.

According to the efficient market hypothesis, stocks always trade at their fair value on exchanges. That makes it infeasible for investors to purchase undervalued stocks or sell stocks for inflated prices. Therefore, it should be impossible to outperform the overall market through expert stock selection or market timing. However, the only way an investor can obtain higher returns is by purchasing riskier investments.

Assumptions of EMH

An investor might get lucky and buy a stock that brings him huge short-term profits; over the long term, they cannot realistically hope to achieve a return on investment that is substantially higher than the market average. The theory, which carries the same implication for investors, is based on several assumptions about securities markets and how they function. 

The assumptions include the one idea critical to the validity of the efficient markets hypothesis; the belief that all information relevant to stock prices is freely and widely available, “universally shared” among all investors.

The crucial conclusion of the theory is that since stocks always trade at their fair market value, then it is virtually impossible to either buy undervalued stocks at a bargain or sell overvalued stocks for extra profits. 

Neither expert stock analysis nor carefully implemented market timing strategies can hope to average doing any better than the overall market’s performance. If that’s true, then the only way investors can generate superior returns is by taking on much greater risk.

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