The theory of efficient markets is an important idea in economics and investing. It explains how prices in markets, like the stock market, reflect all available information. Let’s break it down into simple concepts that are easy to understand.

What Is the Theory of Efficient Markets?

The Efficient Market Hypothesis (EMH) says that stocks are always traded at their fair value on exchanges. Thus it is impossible to consistently outperform the market using new information, as this information is shared with every other investor.

The theory does not say at a specific moment a stocks value is accurate. At any moment the stock may be under- or over-valued. But in the long term the markets will get things correct.

Types of Market Efficiency

There are three levels of market efficiency. Each one describes how much information is included in the market prices.

1. Weak Form Efficiency

• Prices only reflect past market data, like previous stock prices or trading volume.
• It means technical analysis (studying past prices) doesn’t work to predict future prices.

2. Semi-Strong Form Efficiency

• Prices reflect all public information, such as news, financial reports, and company announcements.
• It means you can’t use public information to consistently outperform the market.

3. Strong Form Efficiency

• Prices reflect all information, including public and private (insider) information.
• It suggests even insider knowledge won’t give someone an advantage.

Implications of Efficient Markets

If markets are efficient, certain strategies and ideas won’t work as well:

No Free Lunch

• You can’t earn extra profit without taking extra risk.
• For example, buying a stock after good news won’t guarantee profit because the news is already reflected in the price.

Hard to Beat the Market

• Professional investors (like fund managers) can’t consistently outperform the market because they use the same information as everyone else.

Focus on Long-Term Investing

• Since short-term profits are unpredictable, investing for the long term might be a better strategy.

Criticisms of Efficient Markets

Not everyone agrees with the Efficient Market Hypothesis. Critics argue that:

• Behavioural Biases: People don’t always act rationally. Fear and greed can create market bubbles or crashes.
• Market Anomalies: Some investors have consistently outperformed the market, suggesting it’s not perfectly efficient.
• Lag in Information: In some cases, prices take time to adjust to new information, creating opportunities for profit.

Summary

The theory of efficient markets explains that prices in the stock market reflect all available information. It suggests:

• It’s hard to consistently outperform the market.
• Prices change quickly as new information becomes available.