The Efficient Market Hypothesis: Why Investing Works

Can you actually make a profit through investing in stocks?

According to the Efficient Market Hypothesis, no. The Efficient Market Hypothesis (EMH) is a theory used to describe the stock market, stating that at any given time and in a liquid market, security prices fully reflect all available information. This means that technicially, it should be impossible to "beat the market" and earn profits off of investing, because stock market efficiency causes existing share prices to always incorporate and reflect all relevant information, meaning that share prices are always equal to their intrinsic value.

There are three major versions of the EMH: "weak", "semi-strong", and "strong", each of which have different implications for how markets work.

• "Weak" form: current prices are determined solely by technical analysis or past prices, and have a cyclical pattern or trends

• "Semi-strong" form: current prices are determined using a mix of technical and fundamental analysis, using public information along with market trends

• "Strong" form: current prices reflect all information, which not only includes all publically available information and market trends, but also insider knowledge

However, for an efficient market to exist, it must satisfy some underlying assumptions:

• A large number of investors analyze and value securities for profit

• Investors have rational expectations and investors' reactions are random and follow a normal distribution pattern

• All information about companies and the stock market is universally available at a low cost

• Stock prices adjust quickly to new information.

• Current security prices reflect all relevant information

• Security prices only change when new information becomes available

But these assumptions are harder to fulfill than they seem. This is particularly true about the assumptions involving investor behavior. In the stock market, many investors tend to overreact or underreact to events or information. Thus, when "good news" is released to to the public, the overall reaction of investors largely determine the change of price of the stock as shown in the diagram below.

In addition to this, some investors often respond adversely to price changes in stocks, making their actions characterized by irrational behavior. When stocks increase towards highs, they buy in hopes of riding the upwards trend, when stocks decline, they sell in fear of incurring more losses. However, such actions may be at points such as market highs or lows, where buying/selling may not be the optimal decision, and investors' emotions skew their behavior.

So, we ask the question again, can you make a profit through investing in stocks?

In some cases, yes. Although the EMH is a fundamental theory of modern financial theory, it is often disputed. There's evidence that high returns from stocks can be achieved year after year. One such case is Warren Buffett, the chairman, president, and CEO of the holding company Berkshire Hathaway. Each year, Berkshire Hathaway's portfolio has managed to "beat the market" for the last few decades, averaging annual returns around 20%. Investors like Buffett, who have found the inefficiences of the market such as undervalued stocks, have found ways to receive steady returns within the market.