Can You Beat the Market? The Efficient Market Hypothesis

The idea that share prices already reflect available information, the evidence for and against it, and what it means for ordinary investors.

If you hear good news about a company, should you rush to buy its shares? According to the efficient market hypothesis, it may already be too late. The idea, developed by economist Eugene Fama in the 1960s and 1970s, is that share prices quickly reflect all available information.

The idea

If markets are efficient, then:

Prices adjust rapidly to new information.
It is very hard to consistently earn higher returns than the market without taking extra risk, because any predictable opportunity would quickly be exploited.
Future price changes are largely unpredictable.

Fama distinguished weaker and stronger versions. The weak form says past prices cannot predict future prices. The semi-strong form says prices reflect all public information. The strong form says prices reflect even private information, a version few people accept.

The evidence for

A large body of research finds that most professional fund managers do not beat the market consistently after fees. S&P’s regular SPIVA reports have found that over long periods, a large majority of actively managed funds in the United States, and in many other markets including India, underperformed their benchmark indices.

The evidence against

Critics, including behavioural economists like Robert Shiller, point to evidence that markets are not perfectly efficient:

Bubbles and crashes, like the dot-com bubble, suggest prices can stray far from fundamental values.
Anomalies, such as the tendency of cheaper “value” stocks or shares with strong recent momentum to outperform at times.
Behavioural biases, such as overconfidence and herding.

In 2013, Fama and Shiller shared the Nobel prize with Lars Peter Hansen, recognising work on both sides of the debate.

The index fund argument

If it is very hard to know in advance which fund managers will beat the market, many investors conclude it is better to buy a low-cost index fund that simply owns the whole market. Their returns will match the market minus a small fee, which, after costs, often beats the average active fund. This reasoning drove the huge growth of index funds.

What it means for you

Even if markets are not perfectly efficient, beating them consistently is difficult. For most ordinary investors, diversification, low costs and a long-term approach matter more than trying to pick winners.

Thinking efficient markets means prices are always right

Efficiency means it is hard to predict price changes and earn excess returns, not that prices are always correct. Prices can be wrong, but if no one can reliably tell in advance which way, they may still be hard to beat.

Key takeaways

The efficient market hypothesis says prices quickly reflect available information.
Most active funds fail to beat their benchmarks over long periods after fees.
Bubbles, anomalies and behavioural biases suggest markets are not perfectly efficient.
For most investors, diversification and low costs matter more than trying to beat the market.