EMH Forms Explained

There are three forms of the efficient markets hypothesis. In this article, we will explain each form and go over some examples/questions for each.

1) Strong form EMH

2) Semi strong form EMH

3) Weak Form EMH

Before we can begin to understand what this means we have to understand two concepts.

1) Investments are expected to return a certain amount given the risk level of the investment. Some models measure risk using beta.

2) when an investor generates greater returns than what would be expected for the amount of risk taken the excess is called alpha.

The EMH states that all relevant information is already priced into stocks and that no informational advantage will produce excess returns over the long term. The three types of EMH each specify which types of information are already fully priced in.

Weak form EMH states that only market trading data is priced in. For example, no investor could beat the market by analyzing price charts.

Semi-strong form EMH states that both market trading data and all other publicly available information are priced in. For example, analyzing the companies press releases and financial statements will not allow you to beat the market.

Strong form EMH states that all data is already reflected in stock prices including insider information. for example, under this form of EMH, you wouldn't be able to beat the market even if had the CFO sending you insider information.

Question 1)

Your childhood friend Alice is the CEO of the Tom Motorhome Co. She agrees to send you a copy of the quarterly financial statements before they are released to the general public. You use this information to make investments but find that you have been unable to outperform despite getting the financials from your friend. Which form of EMH does this violate?

Answer: None

Question 2)

You conduct a thorough study of historical price data and believe you have found a pattern. You trade the pattern for a year and are surprised to find you have outperformed significantly. Which form(s) of EMH have been violated?

Answer: All forms

Question 3)

Your friend Warren Hathaway spends extensive amounts of time analyzing the financial statements of insurance companies. Over a 20 year period, he has outperformed by a large margin. Which form(s) of EMH have been violated?

Answer: Semi-strong and Strong