Market efficiency: What it is
The market efficiency hypothesis states that financial markets reflect all available information in current share prices. In an efficient market, share prices are therefore “correct”, so to speak, in the sense that there are no systematic mispricings that an investor could exploit. Price changes are mainly caused by new information that was not previously known. As soon as new information becomes public, it is immediately processed by market participants, which leads to a prompt adjustment of the price. This concept implies that it is very difficult to beat the market in the long term. If prices already price in all known information, there are no more insider tips; any under- or overvaluations would be immediately offset by "arbitrage-hungry" investors. It is often metaphorically said that a monkey blindly throwing darts at the financial page of a newspaper would have as good a chance as a professional if the markets were really efficient. In other words, stock-picking or market timing does not provide a systematic advantage in a perfectly efficient market.
Notably, market efficiency does not mean that prices never fluctuate or that they perfectly reflect the “true” intrinsic value of a company at any point in time. Rather, it means that any deviations from intrinsic value are purely random and unpredictable - there is no reliable pattern that an investor can use for guaranteed outperformance. The EMH is therefore closely related to the random walk of share prices: When all available information is already priced in, price changes move randomly (or at least as if they were random). This concept is central for private investors because it fundamentally influences the prospects of success of various investment strategies (e.g. active stock-picking vs. passive investing).
The roots of the market efficiency idea go back over a century. As early as 1900, the French mathematician Louis Bachelier assumed in his dissertation that share prices follow a random process. He found that past, current and even expected future events are included in the current price, without it being possible to derive simple predictions for future price changes. Bachelier was thus ahead of his time; his work was forgotten for a long time until it was rediscovered by statisticians and economists (including Paul Samuelson) in the 1950s.
In the 1960s, advances in information technology laid the foundations for systematic studies of the financial markets. In 1965, the economist Paul Samuelson formulated a theory that in a market that processes all information, price changes must be unpredictable, otherwise resourceful investors would immediately exploit and thus eliminate any predictability. Independently of this, the young financial scientist Eugene F. Fama at the University of Chicago was investigating share price developments at the same time. Through extensive statistical analyses, Fama confirmed what Samuelson had logically deduced: share price changes are not predictable, they do not follow a pattern from which profits can be easily made. In 1965, Fama coined the term “efficient market”, in which “prices fully reflect all available information”.
Fama's work, including his overview article from 1970, made the market efficiency hypothesis a central paradigm of finance. In this context, he also defined the various forms of market efficiency and summarized the state of research at the time. The 1970s and early 1980s are considered the heyday of the EMH in the academic world, and it was regarded by many economists as virtually proven. The financial researcher Michael Jensen even went so far as to claim in 1978: “There is no other postulate in economics for which there is stronger empirical evidence than for the market efficiency hypothesis”. This strong formulation shows how important the EMH had become.
At the same time, growing confidence in market efficiency also led to changes in practice: in 1975, the first index fund for private investors was introduced in the USA, inspired by the idea that active fund managers cannot beat the market anyway. Fama himself was awarded the Nobel Prize in Economic Sciences in 2013 (together with Robert Shiller), an honor both for his pioneering work on market efficiency and for his overall work in financial market research.
The three forms of EMH
Eugene Fama divided the EMH into three types, depending on the amount of information that is assumed to be “contained in the price”:
Weak market efficiency: In the weak form, the current price reflects all the information that was contained in the price trend in the past. In particular, all historical prices and trading volumes have already been taken into account. Consequence: Technical analysis, i.e. the attempt to derive future price movements from chart patterns or historical price data, is doomed to failure. Past trends offer no reliable advantage as the market has already processed them. However, fundamental information remains incompletely priced into this form of efficiency. This means that fundamental analysis, for example through the evaluation of company key figures, business models or macroeconomic factors, continues to offer potential for achieving above-average returns. Those who analyze better than the average can theoretically still make use of an information advantage here.
Semi-strong market efficiency: This intermediate form assumes that all publicly available information is included in the current price. This includes, for example, news, balance sheets, economic data, analyst reports, etc. Consequence: No publicly available information can be used to beat the market. Neither chart analysis nor fundamental analysis (the analysis of key business figures, news, etc.) deliver excess returns, as new publicly available information is immediately priced in. An example: When a company presents surprisingly good quarterly figures, the share price typically rises within minutes or even seconds. Anyone who only buys the next day is too late, as the information is already included in the share price.
Strong market efficiency: In its strongest form, the EMH states that all information, both public and private (especially insider information), is included in the price. In other words, even an insider with confidential prior knowledge could not gain an advantage because this non-public information would also already be priced in. Consequence: No investor can systematically beat the market, not even through insider trading or specialized knowledge. This strong form is considered a theoretical extreme and obviously does not fully hold up in practice - after all, insider trading scandals show that people with exclusive knowledge can make profits before the general public is informed.
In reality, the stock market is often regarded as “fairly efficient” in its weak and semi-strong form, while hardly anyone considers the strong form to be realistic. In practical terms, this means that past price patterns and public news offer little approach to outperforming the market, but it is quite possible for insiders or other people with hidden knowledge to have a short-term information advantage.
Critics
Despite its broad acceptance in academia, the market efficiency hypothesis is not uncontroversial. Critics particularly criticize the fact that the EMH is based on an idealized investor image; a rationally acting market participant with complete information processing. However, reality shows that people often act emotionally, are subject to psychological distortions (e.g. herd behavior, overoptimism, loss aversion) and often perceive information selectively. These points of criticism have led to the development of behavioral finance, which can better explain many market phenomena, such as the emergence of speculative bubbles or the systematic occurrence of anomalies such as the value or momentum effect. The so-called “Grossman-Stiglitz paradox” is also called into question by the EMH: if markets were actually completely efficient, there would no longer be any incentive to analyze information, but without information analysis, efficient prices could not arise. Many researchers and professionals therefore agree that markets are often efficient, but not always. The market can make systematic mistakes, especially when emotions, uncertainties or new technologies come into play.
Meaning for private investors
However, this does not mean that stock picking is pointless per se. If you take a rational, data-based approach and diversify broadly enough, you can benefit from market inefficiencies in a targeted manner. By investing in individual stocks, you can directly control the weighting in sectors and regions and thus benefit better from long-term trends. However, finding these opportunities takes time and requires expertise.
With the Obermatt platform, you can find these “stock pearls” and opportunities in markets easily and completely free of emotion.
Conclusion
The market efficiency hypothesis has profoundly shaped our understanding of financial markets and provides important arguments for passive investing. It cautions against over-reliance on short-term forecasts and emphasizes how difficult it is to systematically beat the market. Nevertheless, market efficiency does not mean that all opportunities have disappeared. It is precisely because many market participants act emotionally or short-sightedly that inefficiencies arise from time to time and this is the starting point for data-based stock picking.
Private investors can benefit from these opportunities if they take a disciplined, broadly diversified and systematic approach. Emotions, speculation and blind actionism have no place on this path. Instead, sound data, objective valuations and a clear strategy are required.