The efficient markets hypothesis (EMH) argues that markets are efficient, leaving no room to make excess profits by investing since everything is already fairly and accurately priced. This implies that there is little hope of beating the market, although you can match market returns through passive index investing.
Example:
Peter holds 850 shares of a technology company that currently trade at $125.36 per share. His best friend, who is an insider in the company, informs Peter that the stock price will decline over the next days because the company has failed in a project.
Peter does not believe his friend and holds all his shares. A week later, the technology company announces the failure of the deal, and the stock price starts declining sharply, dropping to $105.12 in a couple of days.
The market is efficient and adjusts immediately to the newly available information, in this case, the company’s announcement about the failed deal. To realize a gross gain, Peter should have sold some of his shares at $125.36 per share as soon as the market adjusted to the newly available information. Instead, he held all his shares, thus losing money.
If Peter had sold 400 shares at $125.36 per share, he would realize a gross gain of $50,144. Now that he held all his 850 shares, his loss is 850 x $125.36 – 850 x $105.12 = $106,556 – $89,352 = $17,204.
Though the efficient market hypothesis theorizes the market is generally efficient, the theory is offered in three different versions: weak, semi-strong, and strong.
The weak form suggests today’s stock prices reflect all the data of past prices and that no form of technical analysis can aid investors.
The semi-strong form submits that because public information is part of a stock's current price, investors cannot utilize either technical or fundamental analysis, though information not available to the public can help investors.
The strong form version states that all information, public and not public, is completely accounted for in current stock prices, and no type of information can give an investor an advantage on the market.