What is the Efficient Market Hypothesis (EMH)? Theory vs. Reality

The Efficient Market Hypothesis (EMH) claims that asset prices reflect all available information. Explore why quants exist in an 'efficient' world.

Twelve hours analyzing the 'Post-Earnings Announcement Drift' proved that the Efficient Market Hypothesis (EMH) is a useful framework but a flawed reality. EMH, developed by Eugene Fama in the 1960s, asserts that financial markets are 'informationally efficient,' meaning prices always reflect all available information.

If EMH held perfectly, it would be impossible to consistently achieve returns above the market on a risk-adjusted basis. The theory is divided into three forms:

1. Weak Form: Past prices and volume data are already reflected in current prices. Technical analysis is useless. 2. Semi-Strong Form: All public information (earnings, news) is reflected. Fundamental analysis is useless. 3. Strong Form: All information, including private/insider information, is reflected. Even insiders cannot beat the market.

The Grossman-Stiglitz Paradox states that if markets were perfectly efficient, no one would have an incentive to gather information, which would lead to the market becoming inefficient. Therefore, markets must be 'efficiently inefficient.' Quants exist in the gap where information is being processed but not yet fully reflected in the price. The time it takes for a market to reach equilibrium after new data arrives is the window for alpha, exploited by both mean reversion and momentum trading strategies.

A key implication of EMH is that price changes should follow a random walk. We can test this using the Variance Ratio test.