Question

If as an investor you believe the semi-strong form of the Efficient Markets Hypothesis is true, what is your rational investment strategy?

Explain and justify the strategy.

Answer 1

Solution:-

Semi-strong efficient market hypothesis believes that stock prices are very efficient in discounting any publicly available information, such that any new piece of information gets absorbed and adjusted in prices very quickly. thus, markets are very efficient, correctly value a stock and any change in stock prices come only due to a new piece of information and that too gets absrobed and adjusted very rapidly.

Due to above reasons, the use of technical analysis and fundamental analysis doesn't work and market can't be outperformed using those strategies.

What should be a rational investment strategy in such a case?

The most rational strategy in such a case is to invest in a fully diversified index fund which will replicate the performance of the market. This is the most rational strategy because in semi-strong EMH, we believe that markets can't be putperformed, i.e. we can't beat the market but we sure can take advantage of the returns of the market. The way to do it is through investment in an index fund (e.g S&P500 index fund) which represents the performance of the overall market. This way we will be able to achieve the same returns as the broader market without taking any extra risk.

Index funds are mutual funds which have the same investment composition as that of an underlying index (i.e. S&P500). Investing in an S&P index fund is like investing directly in S&P500. This is a way to invest in the broader market rather than trying to do stock picking by finding undervalued stocks which is against the principles of semi-strong EMH.

Such a portfolio based on index funds will represent the principles of semi-strong EMH and provide market returns without taking more than normal risk.