Chapter 2: FAQs 83
What is the Efficient Markets
Hypothesis?
Short Answer
An efficient market is one where it is impossible to beat
the market because all information about securities is
already reflected in their prices.
Example
Or rather a counter-example, ‘‘I’d be a bum in the street
with a tin cup if the markets were efficient,’’ Warren
Buffett.
Long Answer
The concept of market efficiency was proposed by
Eugene Fama in the 1960s. Prior to that it had been
assumed that excess returns could be made by careful
choice of investments. Here and in the following the
references to ‘excess returns’ refers to profit above the
risk-free rate not explained by a risk premium, i.e., the
reward for taking risk. Fama argued that since there
are so many active, well-informed and intelligent mar-
ket participants securities will be priced to reflect all
available information. Thus was born the idea of the
efficient market, one where it is impossible to beat the
market.
There are three classical forms of theEfficient Markets
Hypothesis(EMH). These are weak form, semi-strong
form and strong form.
Weak-form efficiency In weak-form efficiency excess returns
cannot be made by using investment strategies based on
historical prices or other historical financial data. If this
form of efficiency is true then it will not be possible to
