Eugene Fama Proposed the Efficient Market Hypothesis

In 1970, Eugene Fama proposed the Efficient Market Hypothesis (EMH) in a

landmark paper Efficient Capital Markets: A Review of Theory and Empirical

Work. The fundamental idea behind the EMH is that securities markets are

efficient in incorporating all information that determines the value of a security.

As a result, investors cannot achieve better risk-adjusted returns than by holding

the market portfolio. EMH has three versions. (i) The weak form of the EMH

says that the asset price fully reflects all past market price information. If the

weak EMH holds, technical analysis that relies on past price actions cannot

outperform the market on a risk-adjusted basis. (ii) The semi-strong form of the

EMH posits that the asset price reflects all publicly available information. If the

semi-strong EMH holds, fundamental analysis that relies on public accounting

information is futile. (iii) The strong form of the EMH claims that the asset price

reflects all information, including all non-public information. If the strong EMH

holds, no investor can outperform the market on a risk-adjusted basis.

The EMH triggered an on-going debate within the academic community. Since

corporate insiders with material non-public information can capture higher risk-

adjusted returns, researchers generally agree that the strong EMH does not hold.

There is no consensus on whether the weak EMH and the semi-strong EMH

hold. Defenders of the weak EMH and the semi-strong EMH argue that any

inefficiency in the market will be immediately arbitraged away by smart market

participants. Sharpe and Alexander (1990) defined arbitrage as “the

simultaneous purchase and sale of the same, or essentially similar, security in

two different markets for advantageously different prices.” In other words, if

there are any market anomalies—patterns in the financial market that contradict

the EMH—that produce high risk-adjusted returns, investors will immediately

act on them and restore the market efficiency if the information is publicly

available. Naturally, many empirical studies by critics of the EMH are

dedicated to identifying market anomalies that reflect possible market

inefficiencies. In this book, we will discuss a variety of successfully identified

anomalies. The existence of these anomalies casts serious doubt on the EMH.

Besides investors’ behavioral biases and irrationality, the market structure also

contributes to sustained mispricing of assets. For instance, there are institutional

obstacles to the dissemination of negative information about stocks. Since

analysts need access to senior managers of a firm to have a competitive edge in

gathering information about the firm, they are more reluctant to make sell

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