Question

Provide a discussion on the central idea of EMH, forms of market efficiency and tools investors may use to try to outperform the market.

Answer 1

The Efficient Market Hypothesis (EMH) essentially says that the prices of investment securities, such as stocks reflects all relevant information. The market values of the securities are always true and the future prices are randomly depending on the randomly available information in the market. In such market condition, an active investor cannot beat the market continuously. But a passive investor can make profit like in the active investor. Therefore as per EMH, it is not possible to beat the market or achieve above-average profits continuously.

Forms of efficiency

1. Weak form EMH : In this form of market efficiency the securities prices reflects the past prices and volume trading information. Moreover past price performance has no impact in the future performance. So technical analysis is not able to provide information about future. Only fundamental analysis is helpful.
2. Semi-strong form EMH : In this form, neither fundamental analysis nor technical analysis can provide an information on prices to the investors in the market. Becuse the stock prices reflect quickly the new information. This form is weak efficient as well.
3. Strong form EMH : All types of information, both public and private, are reflected in the prices of the stocks and that no type of information provides the investors the advantage. Strong form EMH states that profits are impossible.

The following are the methods or tools to outperform the market

• Diversification : The most accepted tool is diversification. Diversification is the process of investing the securities of different asset classes that is both debt and equity. The investors can diversify the portfolio with different assets that perform differently in the phases of the business cycle. This will reduce the risk and the securities will outperform.
• Value investing : Investors can beat the market by only selecting stocks that outperform. Value investors pick out stocks they think the stock market is underestimating. The stocks that appear to be trading at less than their intrinsic or book value.
• Use of technical analysis : Technical analysis interprets the price trends and identifies the best time to buy and sell a security with the use of charts and graphs. It considers price as an important factor that tells the trend of price of securities in the short term. This will help the investors to outperform.