The theory is based on the efficient market hypothesis (EMH), formulated by Eugene Fama in 1970 which states that all pertinent information regarding the stock market or a specific stock is readily available to everyone. Advocates of this theory believe that investors cannot outperform the market and that stock prices change randomly and independently of one another. Due to this, say the followers, there is no way that investors can predict the outcome of a stock.
Market efficiency is thought to exist in three different forms:
In this form, the market prices are said to incorporate the past performance and returns. That is, everyone is in the know on how any particular stock has performed in the past. Therefore, using technical analysis, which attempts to suggest future stock performance based on past activity, will be useless in one’s attempt to outperform others since everybody will be doing the same thing anyway!
However, in this weak form of market efficiency, an investor may have an advantage over others if he/she evaluates other related information such as the overall economy, industry conditions, financial conditions and management of companies. This is referred to as fundamental analysis which is an attempt to measure a stock’s intrinsic value.
In this form, market prices not just incorporate past performance and returns, but also all related public information. That is, the market reacts immediately to information as soon as it is made public. Therefore, in this scenario, neither technical nor fundamental analysis will provide any advantage to investors. The only way for anyone to outperform the market is if one has access to non-public information.
In this form, all information—public or private—related to the stock market is incorporated into the prices. In this case, it is impossible for any investor to gain any advantage over the rest of the market.
The theory is not without its own share of criticisms, however. Many of its critics argue is that the stock market has a certain degree of predictability. One form is in the phenomenon known as the “January effect” wherein higher than usual returns tend to be earned on the first month of the year. The phenomenon, however, has not occurred in years because the markets have adjusted for the effect. (1)
One other evidence that the critics present is a similar phenomenon called the “weekend effect” wherein stock prices tend to be higher from Friday to Monday. Further, they also show evidence of a number of people who have consistently outperformed the market and made millions out of it. One such person is Warren Buffet.
The advocates of EMH, however, argue that while these so-called predictable phenomena do occur, they only do so in a random fashion. Furthermore, these phenomena occur such that the overall market performance tends to return to its mean value. As for the fact that a number of people have consistently outperformed the market, the disciples of EMH argue that while it is true that some people have made outrageous profits from using analysis tools, they are merely lucky. EMH followers further state that, with the huge number of investors in the market, there will always be some who outperform the market, plenty who perform at the same level as the market, and some who perform below the market. This is said to be consistent with the laws of probability.