The Efficient Market (Hypothesis)- Fact and Myth for the CFA L1 Exam

For most of the CFA curriculum we’re concerned with traditional finance which is built on the assumptions of:

  • Rational Individuals
  • Perfect Information
  • Efficient markets that quickly absorb new information into prices

Behavioral economic theories modify these models by relaxing certain assumptions.  Behavioral finance acknowledges that people aren’t economic machines. We are weird. We don’t always act rationally. We make mistakes in processing things. On top of that, perfect information doesn’t exist. It’s impossible to know everything about everything at all times. This means that there are informational, cognitive, and emotional challenges to the theory of efficient markets.

But this blog post is all about understanding the base case of efficient markets. 

What is the Efficient Market Hypothesis?

An efficient market is one where prices accurately reflect all information. The efficient market hypothesis (EMH) states that markets are informationally efficient when the price of securities quickly, fully, and rationally adjust to new information. Statistically, we’d say that security prices are an unbiased estimator of their true value. Think of it this way, in an efficient market:

  1. The price is right: In other words, asset prices reflect all available information and prices adjust instantaneously to incorporate that information
  1. There is no free lunch: Since prices adjust immediately it is not possible to get an informational advantage and therefore earn above-average returns. In other words no alpha is consistently possible

Put differently, if markets are efficient there should be no risk-adjusted returns possible from trading on publically available information. Thus an efficient market favors a passive investment strategy over a more expensive active strategy. This efficient market hypothesis is best captured by the CAPM model.

Intrinsic and Market Value under Efficient Markets

The concept of perfectly priced securities speaks to the idea of market value vs. intrinsic value.

Market value is the current price of an asset. It’s what you can buy/sell it for.

Intrinsic, or fundamental, value is the value that a rational investor with full knowledge of the asset would willingly pay. In other words, it’s what an asset should be worth. Intrinsic values can’t be known outright and are always estimated.

If a market is always priced correctly because it has all the information the implication is that you can't really earn alpha. In other words, no positive risk adjusted returns are possible in such a market. And the implications for portfolio managers is that your mandate isn't to beat the market. It's to look at other ways you can add value, whether that's through tax optimization, or identifying what the optimal sort of risk levels are for an individual, and putting your portfolio on that.

In summary: 


  • In efficient markets the market value of an asset should be close to its intrinsic value
  • In inefficient markets, however, an investor could attempt to estimate intrinsic value and trade on any perceived price differences between their estimate and the market price.

Factors contributing to an Efficient Market

There are a number of factors that contribute to an efficient market. These include:

  • Number of participants – The higher the better (participants include investors, analysts, traders, etc.)
  • Availability of information – The more info / the more widely available the better
  • Barriers to trading – The fewer trading impediments the better. If a pricing discrepancy leads to an arbitrage opportunity, the ability for market participants to buy/sell and take advantage will force prices closer to their intrinsic value and reduce inefficiencies
  • Transaction / Information costs – If the cost of obtaining information or actually buying / selling securities is higher than the potential mispricing of a security, then deviation from the intrinsic price can persist

Challenges to the Efficient Market Hypothesis

The efficient market hypothesis (EMH) states that the price of securities quickly, fully, and rationally adjusts to new information.

The reality is that markets are never likely to be perfectly efficient.


Trading or gathering information has transactions costs, and more importantly the assumption that all the relevant information is both available and incorporated into market prices instantly is subject to frequent challenges.

There are three challenges to the ‘Efficient Market Hypothesis (EMH): weak, semi-strong, and strong. Each relaxes the assumption of perfect information to a different degree.

If you understand the table that follows you do not need to read the subsequent clarifications.

Challenges to efficient market hypothesis - CFA L1

In the table above we’re moving from less information being incorporated into prices to ALL information being incorporated. So the Semi-strong form encompasses all of the information that the weak-form hypothesis states plus non-market public information such as dividend announcements, financial ratios, and news. Similarly, the strong form adds non-public (insider) information to what is known and hypothesizes that no alpha is possible.

In general the semi-strong form of EMH is the most widely supported, particularly in developed countries, and the strong-form of EMH is not believed to hold as insider-trading can lead to positive risk-adjusted returns

Weak Form Modification

So the weak form hypothesis says that current market prices reflect all of our past price and volume data and information. And the implications of that are that charting techniques, technical analysis, and trading can't generate excess returns, because all of that information is already incorporated into prices. Fundamental analysis may actually lead to alpha under the weak form hypothesis.

Semi-Strong Form Modification

So, the semi strong form is essentially the weak form, which is that all past price data and volume is reflected in current market prices, plus it adds in the fact that all publicly known information about that security or company is already incorporated as well. And so not only is technical analysis not a viable source of alpha, but fundamental analysis also doesn't lead to the ability to earn excess returns. But if you do have insider or material nonpublic information on a security, it could possibly lead to alpha (and this is generally thought to be true).

Strong Form Modification

And then the strong form builds on the semi strong form, predictably, right, and says, "Okay, all information is incorporated in security prices, and that includes nonpublic information." As a result, you just can't earn alpha. Everything's already factored into the stock price. So these challenges, right, you need to are going to need to know them. You might need to talk about their implications and what it means for portfolio managers' behavior. But it's also worth noting that sort of this efficient market hypothesis which these are attacking, is generally thought to sort of hold true for the most part, with some exceptions.

So, the exceptions or anomalies you get pointed out are large cap stocks are generally thought to be more efficient than small cap, or value investing leads to outperformance over other forms of investing, like growth, right, and so potentially a challenge certainly falls into sort of the weak form bucket there. But some counters to that are simply stating that, "Okay, well they might show higher returns, but that's just reflecting that there are riskier strategies." We've also seen sort of calendar anomalies, like the January effect, where stocks tend to rise, which challenge this weak form hypothesis.

And so, I think what you should take away from it is in theory, right, you have the efficient market hypothesis is and then three challenges to EMH based on informational gaps. The weak form, semi strong form, and strong form challenges will be tested, so don’t get caught by surprise.

Summarizing the Efficient Market Hypothesis

If markets are either semi-strong or strong-form efficient than active management is not likely to generate consistent alpha. You are better off pursuing a passive investment strategy. Thus the role of a portfolio manager is less about beating the market and more about crafting the most efficient strategy in the context of an investor’s risk and return constraints.

In our next post we'll cover the list of specific observed market anomolies.  





[1] The exception is the lengthy dive into behavioral finance for Level 3.