The Efficient Market Hypothesis is a core financial theory which states that markets are fully efficient and assets always trade at fair value. According to the EMH, an investor/trader would fail to make excess returns over and above a buy and hold strategy on the same asset. For example, if a trader buy a FTSE100 Index and holds for 12 months, it would perform the same as if not better than being active with the same index in the same 12 month period, ie; opening and closing positions weekly/monthly depending on the given strategy. Of course, there is the consideration of  extra transactions costs with an active strategy therefore any gains would need to be substantial in order to out perform once costs as deducted. 

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Does the Hypothesis Hold?

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Well to answer the question, the evidence is mixed and generally is dependant on sample characteristics, ie: markets tested, time frame, strategy etc. However, thats not to say that a simple index fund is the way to go - Wall Street is full of investors/ traders who use historic data to help predict future returns. Look no further than infamous investor Warren Buffet, arguably the most famous and profitable investor of our time who implemented a strategy based around finding value stocks; that is, stocks that are trading in the market below what the financials statements suggest.

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The finer intrequesties of the EMH are available all over the internet but can be somewhat boring to those non finance enthusiasts therefore we will brush by them for the sake of this article. What investors really want to know is how to outperform an index fund that has been offered or mentioned to you by a friend at the golf course. Well in short, there is no easy way, no shortcuts - nothing other than good old fashioned research, just like Buffet; and even then, there are no guarantees. 

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With that being said, there are strategies for different markets, from stocks to foreign exchange to OTC derivates, that have stood the test of time, therefore punching holes in the EMH. 

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Fundamental vs Technical Analysis

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The two main types of analysis that both challenge the EMH are fundamental and technical analysis, however there are some key differences between the two. For example, fundamental analysis is the use of historic financial data in order to value an asset ie; stocks. Fundamental analysis in the foreign exchange market would be dependant on economic models such as PPP, IRP, Ballassa-Samuelson.etc, all of which use theory to spot for discrepancies in currency valuations that will eventually be arbitraged away. In contrast, Technical Analysis is the use of advanced charting platforms to spot consistent patterns and structures in order to predict future prices, although, is largely subject to the trader being able to spot, as there is no checklist/ scientific strategy like is available with fundamental analysis. 

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As previously mentioned, the evidence against the EMH is mixed and is largely dependant on the tested criteria. What we do know is that technical analysis in developed stock markets is rarely used by industry professionals but rather more the norm in currency and commodities markets.

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So how does any of this help? Well, It is crucial to understand the basic dynamics and what you are trying to achieve if you are going to risk your hard earned cash. It is very difficult to outperform an index fund using an active strategy, unless you have mastered a certain technique or strategy that has been proven over time, otherwise the markets are not for the faint hearted. 

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On a final note, the internet is littered with technical analysis 'tips/secrets', attempting to sell you information that is basic and readily available on thousands of site across the internet. I wrote an article on the stigma social media and the so called 'forex traders' are creating, however what you should bear in mind is that if it seems to good to be true it usually is, and if it were so easy we would all follow simple strategies, that in the context of the EMH, would make it even more difficult to spot inefficiencies and make excess profits.

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Remember:

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• There are inefficiencies in the markets that can be exploited for excess returns

• The characteristics (market, time horizon, strategy) dictate the ability to outperform

• Technical/Fundamental analysis both challenge the EMH therefore provide opportunities to earn excess returns over a comparable index

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