Though the efficient market hypothesis as a whole theorizes that the market is generally efficient, the theory is offered in three different versions: weak, semi-strong and strong.
The basic efficient market hypothesis of investment posits that the market cannot be beaten because it incorporates all important determinative information into current share prices . Therefore, stocks trade at the fairest value, meaning that they can’t be purchased undervalued or sold overvalued. The theory determines that the only opportunity investors have to gain higher returns on their investments is through purely speculative investments that pose substantial risk.
The three versions of the efficient market hypothesis are varying degrees of the same basic theory. The weak form suggests that today’s stock prices reflect all the data of past prices and that no form of technical analysis can be effectively utilized to aid investors in making trading decisions. Advocates for the weak form efficiency theory allow that if fundamental analysis is used, undervalued and overvalued stocks can be determined, and investors can research companies’ financial statements to increase their chances of making higher-than-market-average profits.
The semi-strong form efficiency theory follows the belief that because all information that is public is used in the calculation of a stock’s current price, investors cannot utilize either technical or fundamental analysis to gain higher returns in the market. Those who subscribe to this version of the theory believe that only information that is not readily available to the public can help investors boost their returns to a performance level above that of the general market.
The strong form version of the efficient market hypothesis states that all information – both the information available to the public and any information not publicly known – is completely accounted for in current stock prices, and there is no type of information that can give an investor an advantage on the market. Advocates for this degree of the theory suggest that investors cannot make returns on investments that exceed normal market returns, regardless of information retrieved or research conducted.
There are anomalies that the efficient market theory cannot explain and that may even flatly contradict the theory. For example, the price/earnings (P/E) ratio shows that firms trading at lower P/E multiples are often responsible for generating higher returns. The neglected firm effect suggests that companies that are not covered extensively by market analysts are sometimes priced incorrectly in relation to true value and offer investors the opportunity to pick stocks with hidden potential. The January effect shows historical evidence that stock prices tend to experience an upsurge in January.
Though the efficient market hypothesis is an important pillar of modern financial theories and has a large backing, primarily in the academic community, it also has a large number of critics. The theory remains controversial, and investors continue attempting to outperform market averages with their stock selections.