Efficient Market Hypothesis
The Basic Idea
The efficient market hypothesis is an economic theory which stipulates that the prices of traded assets, like stocks, reflect all the publicly available information of the market.1 This means that if you are investing in assets based on public information, it is impossible to outperform the market over time, because buyers and sellers are working with this same information.2 The efficient market hypothesis is part of liberal economic thought, as it follows neoliberal thought of the efficient free-market that does not require any intervention.
In order to better understand the efficient market hypothesis, it is first important to understand basic stock investing. At its simplest level, stock prices will change based on positive or negative information about the corporation to which they belong. This is because if an investor hears good news about a corporation, they will likely go buy stocks of this corporation, thus driving up the stock price. If an investor hears bad news about a corporation, they might sell their stocks, therefore lowering the stock price.
The efficient market hypothesis suggests that there is a direct relationship between news (or information) and prices, as buyers and sellers generally have access to the same information. If prices move according to public information, they occur efficiently (in a timely manner), which means that stocks are trading at their ‘fair’ price.3
Information cannot be predicted by the general public, as proponents of the hypothesis say that the market is random. Therefore, it follows that investors cannot ‘beat’ the market by buying undervalued stocks or selling inflated prices. Although you might get lucky once or twice, the efficient market hypothesis suggests that you cannot consistently outperform the market average when it comes to investment returns.3 Investors therefore have to make decisions through speculation, which has great risks.4
For example, you might now be sitting at home thinking that you should have invested in Zoom, whose stock prices increased by more than 100% since COVID-19 began.5 However, before the pandemic, these stocks weren’t ‘undervalued’, because no one could have predicted a global shutdown that forced millions to work from home. According to the efficient market hypothesis, based on publicly available information, it would have been impossible for you to realize that Zoom stocks would increase in price until they already had, at which point you wouldn’t make as much by buying stocks at the new inflated price.
I’d compare stock pickers to astrologers but I don’t want to bad mouth astrologers.
– Eugene Fama, the ‘father’ of modern finance1
About the Authors
Dan Pilat
Dan is a Co-Founder and Managing Director at The Decision Lab. He is a bestselling author of Intention - a book he wrote with Wiley on the mindful application of behavioral science in organizations. Dan has a background in organizational decision making, with a BComm in Decision & Information Systems from McGill University. He has worked on enterprise-level behavioral architecture at TD Securities and BMO Capital Markets, where he advised management on the implementation of systems processing billions of dollars per week. Driven by an appetite for the latest in technology, Dan created a course on business intelligence and lectured at McGill University, and has applied behavioral science to topics such as augmented and virtual reality.
Dr. Sekoul Krastev
Sekoul is a Co-Founder and Managing Director at The Decision Lab. He is a bestselling author of Intention - a book he wrote with Wiley on the mindful application of behavioral science in organizations. A decision scientist with a PhD in Decision Neuroscience from McGill University, Sekoul's work has been featured in peer-reviewed journals and has been presented at conferences around the world. Sekoul previously advised management on innovation and engagement strategy at The Boston Consulting Group as well as on online media strategy at Google. He has a deep interest in the applications of behavioral science to new technology and has published on these topics in places such as the Huffington Post and Strategy & Business.
