The Efficient Market Hypothesis, or EMH, is a concept developed by Eugene Fama, which asserts that the prices of financial instruments, reflect all known information about the future values and beliefs of the investors about those particular financial instruments. This means that you, the investor, cannot outperform the market in the long run.
Here is a quick example: Suppose you watch the evening news, and there is a report of how High-Tech companies are getting more popular. You think to yourself it will be a good investment, and you decide to buy stocks of High-Tech companies. Will you outperform everybody? probably not. What knowledge you have about the stock market is available to each and every individual. This means that you are not the only one that noticed that High-Tech companies are getting more popular and hence, these beliefs are already reflected in the price!
This may mean the price is higher if it were not for that particular belief. Please note that this does not mean that every idea and notion you may have about the market is already reflected in the price. You could predict something that nobody even considered, but that would be luck! You could also think you know how a particular sector or stock would perform and not get it right. This is what happens most of the time. Thus, in the long run, the prices of the financial instrument already reflect the consensus of beliefs about the particular stock/bond/etc and it's future performance.
The EMH is usually divided into three categories: The first is called the Weak Form Efficiency. This means that you cannot outperform the market in the long run by using historical prices. This includes Technical Analysis and other statistical methods. For example, You may analyze past prices and see that on a Monday, stocks usually rise by 2%. You think you have a good shot at making some money out of it. The problem is that everybody has access to past prices and everybody would try to make money that way and hence the price would already reflect the use of those tools. This may be debatable and some have showed that there are statistical anomalies that have existed over a long period of time (although most have faded away by now).
The second category is the Semi-Strong Efficiency. This means that the prices reflect all known information and news about it, which means that fundamental analysis cannot help you in analyzing the value of the stock because yet again, everybody has access to the news and information.
The last category is, of course, the Strong Efficiency, which means that the prices reflect ALL information and no one can earn excess return. Of course, that would have to take into account, the legal issues of insider trading. For those who do not know, insider trading means that someone INSIDE the company, that has knowledge that the public does not know yet (such as a big merge), uses it for personal gains. If insider trading is not legal, than you could, and people had, outperform the market. Insider trading is very lucrative and that is why each year you can read the news about someone being accused of it.
You could argue and say that you know several stars and hedge funds that outperform the market but do realize this: there are more that fail and the percentage that is consistently outperforming is VERY small. So small in fact, that this be may attributed to sheer luck.
So how efficient are the markets? The bigger the market the more efficient it is usually as more and more people try to use information to help them gain money and outperform it.
The Israeli Speculator is currently pursuing a Master's degree in Financial Engineering and has been involved in investing and the finance community for 5 years.
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