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.