Efficient Markets Hypothesis: Introduction


Whenever there are valuable commodities to be traded, there are incentives to develop a social arrangement that allows buyers and sellers to discover information and carry out a voluntary exchange more efficiently, i.e. develop a market. The largest and best organised markets in the world tend to be the securities markets.

Efficiency in Economics

The concept of efficiency in economics is a general term for the value assigned to a situation by some measure designed to capture the amount of waste or “friction” or other undesirable economic features present. Within this context, it has several quite distinct meanings. For example, allocative efficiency is concerned with the optimal distribution of scarce resources among individuals in the economy. An efficient portfolio is one with the highest expected return for a given level of risk. An efficient market is one in which information is rapidly disseminated and reflected in prices.


The EMH has been the central proposition of finance since the early 1970s and is one of the most contoversial and well-studied propositions in all the social sciences.


The history of the EMH is covered in detail here, Bachelier (1900), Samuelson (1965) and Fama (1970) being the most important papers.


The term ‘efficient market’ was first introduced into the economics literature by Fama in 1965. For this and subsequent definitions, see here.


The term ‘efficient market’ was initially applied to the stock market, but the concept was soon generalised to other asset markets.

Starting Point

Regardless of whether or not one believes that markets are efficient, or even whether they are efficient, the efficient market hypothesis is almost certainly the right place to start when thinking about asset price formation. One can then consider relative efficiency.

Two informal explanations for market efficiency

If one could be sure that a price will rise tomorrow, the asset would be bought today, raising the price, so that it will not, in fact rise tomorrow. Ergo, the price is unpredictable.

The intrinsic value of an asset is implied by the cumulative impact of information we receive as news. Successive news items must be random because if an item of news were not random, that is, if it were dependent on an earlier item of news, then it wouldn't be news at all. After all, news — by definition — is new. If the rapidly price reflects all information (i.e. the market is efficient), then the price will fluctuate randomly.

Academics Versus Practitioners

There is little consensus between the opinions held in academia and industry. Unsurprisingly, most of the support for the EMH comes from the former.

Major Contributor Unrecognised

The American astrophysicist, M. F. Maury Osborne, was the first to publish the hypothesis that price follows a geometric Brownian motion (the distribution of price changes is log normal) (Osborne 1959), and was jointly responsible for the earliest literature identifying the fat tails (Osborne 1959), that price deviation is proportional to the square root of time (Osborne 1959) and nonstationarity (Osborne 1962).


“There is an old joke, widely told among economists, about an economist strolling down the street with a companion when they come upon a $100 bill lying on the ground. As the companion reaches down to pick it up, the economist says ‘Don’t bother — if it were a real $100 bill, someone would have already picked it up’.”
Lo in Lo (1997)


Contrary to popular belief, the EMH does not require that all market participants are rational. Indeed, markets can be efficient even when a group of investors are irrational and correlated, so long as there are some rational traders present together with arbitrage opportunities. See Shleifer (2000).

Not Possible

Grossman and Stiglitz (1980) argued that because information is costly, prices cannot perfectly reflect the information which is available, since if it did, those who spent resources to obtain it would receive no compensation, leading to the conclusion that an informationally efficient market is impossible. See impossible.

Not Refutable

The EMH, by itself, is not a well-defined and empirically refutable hypothesis. See here.


"I believe there is no other proposition in economics which has more solid empirical evidence supporting it than the Efficient Market Hypothesis."
Jensen (1978)

"If the efficient markets hypothesis was a publicly traded security, its price would be enormously volatile."
Shleifer and Summers (1990)

"It is disarmingly simple to state, has far-reaching consequences for academic pursuits and business practice, and yet is surprisingly resilient to empirical proof or refutation."
Lo in Lo (1997)

"Market efficiency survives the challenge from the literature on long-term return anomalies. Consistent with the market efficiency hypothesis that the anomalies are chance results, apparent overreaction to information is about as common as underreaction, and post-event continuation of pre-event abnormal returns is about as frequent as post-event reversal. Most important, consistent with the market efficiency prediction that apparent anomalies can be due to methodology, most long-term return anomalies tend to disappear with reasonable changes in technique."
Fama (1998)

"What, then, can we conclude about market efficiency? Amazingly, there is still no consensus among financial economists. Despite the many advances in the statistical analysis, databases and theoretical models surrounding the efficient markets hypothesis, the main effect has been to harden the resolve of the proponents on each side of the debate."
Lo (2000) in Cootner (1964)

Best Paper

Fama (1970).

Best book

"The Econometrics of Financial Markets" by Campbell, Lo and Mackinlay (1997).

Review/Survey Papers