Here's a simple question: Does the stock market work?
The efficient market hypothesis says yes.
What Is the Efficient Market Hypothesis?
The efficient market hypothesis is the idea that prices on the stock market are, essentially, accurate. Traders use all the available, relevant information about a company when they buy or sell a stock. The result is that no stock is ever undervalued or overvalued for longer than it takes the market to react to new information. Instead, each stock's price either reflects fair value or is moving toward fair value at any given time.
There are two upshots to the efficient market hypothesis. The first is that, under this theory, changes to a stock's price only reflect new information in the marketplace. Either traders have learned something they didn't know before or circumstances have changed causing them to reevaluate existing information.
The second result is that the EMH says it is impossible to consistently "beat" the market. Traders can get above-market returns with good timing or good luck, but since they can never consistently know better than the market overall, in time their performance will level out.
Under this theory the only way to actually outperform the market, on any given individual stock, is to invest based on unknown or unknowable information. For example, a company developing unproven technology or seeking to launch a completely new product. These are risky, more speculative investments.
Varieties of the Efficient Market Hypothesis
There are three forms of the efficient market hypothesis.
This theory says that the market takes all existing information into account, including private and confidential information, when pricing a stock. This is what economists call "perfect information," and is generally a theoretical model rather than a realistic one.
This theory says that the market takes all public information into account when pricing a stock. Under this theory there is no fundamental analysis you can conduct of a company that will beat the market's returns. From one perspective, insider trading laws exist to allow a semi-strong efficient market.
This theory says that the market takes all existing information about a stock's trading history and price into account when pricing it. Under this theory, there is no technical analysis (the analysis of a stock's trading and statistical history) you can conduct that will beat the market's returns, because that information is already incorporated into the stock's price.
Each form of the efficient market hypothesis is essentially a stepped-down version of the last. Under the strong form, stock prices reflect all existing information. Under the semi-strong form, stock prices reflect all public information about a company and its trading history. Under the weak form, stock prices reflect all information about a company's trading history.
Criticisms of the Efficient Market Hypothesis
The chief argument in favor of the efficient market hypothesis is that most market data support it. In general, the stock market moves in a predictable fashion and stock prices tend to quickly find and return to fixed values based on both trading and company performance fundamentals.
The biggest argument against the efficient market hypothesis is that there are exceptions to this rule.
In particular, the stock market is prone to bubbles and crashes that happen relatively often. In recent years, the housing bubble of the mid-2000's led to a stock market crash in 2008 and the dot-com bubble of the late 1990's popped in the early 2000's. Both of these events reflected securities that had become significantly overvalued. In the aftermath, stocks traded well below their theoretical fair value.
The question becomes, in what time frame does the EMH claim to work. Advocates of the theory say bubbles and crashes are how prices return to a baseline; the fact that bubbles pop and crashes recover is in and of itself evidence of an efficient market. The market can simply take several years to cycle back to fair prices.
Critics respond that bubbles should never form in the first place under an efficient market, and that this also ignores the role of human actors. Individual traders might act based on information, but they are also motivated by greed and fear.
The pursuit of speculative profits can drive trading just as much as rational analysis. Loss avoidance can do the same. Too, the efficient market hypothesis assumes that all traders draw the same conclusions from the same information when, in reality, two different individuals might have access to identical information and reach entirely different conclusions.
Why the Efficient Market Hypothesis Matters
If true, the main lesson from the efficient market hypothesis is that traders should not try to beat the market.
Advocates of the EMH argue that at all times, you are better off investing your money in a passive, market-indexed portfolio. By linking your investment to market performance, you will ensure the highest practical rate of return, since the efficient market hypothesis argues that it is not possible to consistently do better than the overall stock market.
What's more, active trading only exposes you to potential loss.
By intervening in your portfolio and trying to do better than the market (for example, by trying to time your trades or find the next hot company), you risk harming your portfolio. Since, hypothetically, you cannot do better than the market, your active trading at best will net you the same results over time as if you had simply invested in a market-indexed fund. At worst, you risk doing worse than the market or even losing money. There is no way to win and lots of ways to lose.