The Efficient Market Hypothesis (EMH), which may also be referred to as the Efficient Market Theory, is a cornerstone of modern financial theory.
EMH boldly argues that it is impossible to consistently outperform the market’s returns, even in the case of financial professionals. Proponents of EMH argue that the only way to consistently outperform the market in the long-term is through insider information because current asset prices reflect all of the relevant news and information.
This hypothesis was taken a step further by American economist Burton G. Malkiel in his famous 1973 book called, "A Random Walk Down Wall Street." In this book, Malkiel outlines his Strong Form Efficiency advancement of the Efficient Market Hypothesis. Under the Strong Form Efficiency theory, all information about a stock is accounted for in the stock’s price and nothing, including insider information, can help investors reliably beat the market. Malkiel embodied this belief and is infamously known for describing earnings estimates, technical analysis, and investment services as “useless.”
Opponents of EMH argue that investors like Warren Buffet, who has consistently outperformed the market over the course of his career, are proof that this theory is inherently false. Since EMH says it is impossible to consistently outperform the market, investors like Buffet shouldn't exist.
Additionally, opponents of EMH point to stock market crashes as further evidence against the existence of an efficient market. The base of this argument is that unrelated stocks shouldn’t all go down together. An example of this would be the drop in tech stocks during the housing-market crash.
Investors know that this part of the Efficient Markets Hypothesis doesn't work because of there have been countless market crashes that have seen unrelated, strong companies lose value in a short period of time, despite being unrelated to the cause of the crash.
While there are a lot of investors who disagree with EMH, there is also ample evidence to suggest some underlying truth. Over a 10-year period that started in 2009, Morningstar compared the returns of active managers with those of related ETFs and index funds. Shockingly, only 23% of the active managers involved in that study were able to outperform their passive-investing counterparts throughout that time period.
Because followers of the Efficient Market Hypothesis do not believe it is possible to identify and exploit inefficiencies in the market, EMH investors choose to spread their money throughout the market to mitigate risk. This includes investing in exchange traded funds (ETFs), mutual funds, as well as other index-related investments.
