The efficient market hypothesis (EMH), is a hypothesis that states that share prices reflect all information and consistent outperformance of the markets is impossible. The EMH assumes that all investors perceive all available information in precisely the same manner. According to the EMH, stocks always trade at their fair value on exchanges, making it impossible for investors to purchase undervalued stocks or sell stocks for inflated prices. Therefore, it should be impossible to outperform the overall market through expert stock selection or market timing, and the only way an investor can obtain higher returns is by purchasing riskier investments.
Now, here’s the interesting bit: It is important to understand that financial theories are subjective. In other words, there are no proven laws in finance. Instead, ideas try to explain how the market works. However, the EMH is a cornerstone of modern financial theory. The majority of financial policies issued in the past fifty years have been following the premise of the EMH and thus have been geared towards providing a situation in which the markets could become efficient. Laws have been put in place defining accounting standards, disclosure of fees, full descriptions of financial products, etc., as to ensure a maximum amount of transparency and equal access to information for all market participants.
Note that fintech is incorporating the EMH into its narrative to legitimize its allegedly noble mission to “democratize finance.”
If the initial statement about the EMH sounds too much like a laboratory case and reality-defying model scenario to you, rest assured: You are not alone. The EMH is highly controversial and often disputed, not least in the field of Behavioral Economics, which takes an entirely different stance towards the market and its participants.