What Is Efficient Market Hypothesis?

Efficient market hypothesis states that all useful information is fully priced into the markets at all times.
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Efficient market hypothesis is an academic theory about the financial markets. At its core, it states that all useful information is fully priced into the markets at all times.

Assuming that this is true, then it is impossible to gain an advantage over other traders using fundamental analysis.

The Problem With This Hypothesis

The problem with this hypothesis is that most its proponents are not investment professionals. Rather, they are casual or academic observers that have never made their living trading the financial markets.

In fact, some of the most successful investors in history have refuted the theory.

Remember, this theory suggests that it is impossible to generate profitable returns over the long-term, no matter what information you have to hand.

One of the most famous rebuttals came from Warren Buffet. He wrote an article called: ‘The Superinvestors of Graham and Dodddsville’.

From my own experience of trading currencies, I have to agree that EMH doesn’t stand up to the realities of how the financial markets operate.

There have been many instances over my career of the markets reacting to a fundamental piece of information. Furthermore, the resulting move from this information has taken months to play out.

A Real-life Example

One of the best examples of this was when the Bank of Japan initiated its fiscal programme of quantitative easing in 2013.

Once the bank had launched its programme, it then stated its target was to see the USDJPY currency pair reach the price level of 110.00.

Even though the markets knew this information within hours of the announcement, the price took several months to reach that price.

Because traders knew the ‘bigger picture’, they took advantage of this gradual ascent and made many pips from that move up.

How To Test Efficient Market Hypothesis

The good news is that you do not have to try and figure out who to believe.

Each week there are many economic figures and news announcements released. Some of these create a surprise that is big enough to generate a move in currency prices.

If the market was 100% efficient, then the price of each related currency would instantly correct. Traders would have no time to enter the market and take advantage of that price move.

The reality is something entirely different. Scenarios that lead to predictable movements in price are very common.

Some moves will play out over months and even years (as in the case of a large shift in central bank policies). Other moves will be more short-term in nature due to surprise event in the markets.

However, most of these moves happen over a long enough period of time. It’s why many professional traders take advantage of long-term price trends.

You can test the ‘efficient market hypothesis’ for yourself. The process is simple. You just need to watch how price moves after the release of an important piece of economic data.

It will be pretty clear that the market is not 100% efficient – and that it is certainly possible to take advantage of these events to make a profit.

Summary

In this article we have learnt what efficient market hypothesis is and its effectiveness compared to fundamental analysis.

Hopefully, you will be able to see for yourself that trading using fundamentals is a far more reliable trading method.

We hope this article will improve your ability to trade profitably in the future.

If you have any questions or comments, feel free to let us know in the comment box below.

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