The efficient markets hypothesis (EMH), popularly known as the Random Walk Theory, is the proposition that current stock prices fully reflect available information about the value of the firm, and there is no way to earn excess profits, (more than the market over all), by using this information.
It deals with one of the most fundamental and exciting issues in finance – why prices change in security markets and how those changes take place. It has very important implications for investors as well as for financial managers. The first time the term “efficient market” was in a 1965 paper by E.F. Fama who said that in an efficient market, on the average, competition will cause the full effects of new information on intrinsic values to be reflected “instantaneously” in actual prices.
Many investors try to identify securities that are undervalued, and are expected to increase in value in the future, and particularly those that will increase more than others. Many investors, including investment managers, believe that they can select securities that will outperform the market. They use a variety of forecasting and valuation
techniques to aid them in their investment decisions. Obviously, any edge that an investor possesses can be translated into substantial profits. If a manager of a mutual fund with $10 billion in assets can increase the fund’s return, after transaction costs, by 1/10th of 1 percent, this would result in a $10 million gain. The EMH asserts that none of these techniques are effective (i.e., the advantage gained does not exceed the transaction and research costs incurred), and therefore no one can predictably outperform the market. Arguably, no other theory in economics or finance generates more passionate discussion between its challengers and proponents.