What is the Efficient Market Hypothesis?
The efficient market hypothesis (EMH), developed by Eugene Fama in the 1960s, states that asset prices fully reflect all available information. Under EMH, it is impossible to consistently achieve returns exceeding the market average on a risk-adjusted basis because any new information is rapidly incorporated into prices. This theory provides the intellectual foundation for index investing.
Three Forms of EMH
The weak form states that prices reflect all past trading data, making technical analysis ineffective. The semi-strong form adds that prices reflect all publicly available information, making fundamental analysis unable to generate consistent excess returns. The strong form claims prices reflect all information including insider knowledge. Most evidence supports the semi-strong form: while markets are not perfectly efficient, they are efficient enough that most active managers fail to beat index funds after fees.
Key Considerations
EMH does not claim markets are always correct, only that mispricings are random and unpredictable. Behavioral finance has identified systematic biases that create temporary inefficiencies, but exploiting them consistently after transaction costs remains difficult. The practical implication for most investors is that low-cost index funds are likely to outperform the majority of actively managed alternatives over long periods.