A securities market say, the market for long-term U. S. Treasury bonds— is informationally efficient if (1) all information relevant to the values of the securities traded can be obtained easily and at low cost and (2) the market contains many buyers and sellers who act rationally on this information.
If these conditions hold, current market prices will have embedded in them all information of possible relevance; hence, future price movements will be based solely on new information as it becomes known.
The Efficient Markets Hypothesis (EMH), which has three forms, formalizes the theory of informational efficiency:
1. The weak form of the EMH holds that all information contained in past price movements is fully reflected in current market prices. Therefore, information about recent trends in a security’s price is of no value in choosing which securities will “outperform” other securities.
2. The semistrong form of the EMH holds that current market prices reflect all publicly available information. Therefore, it makes no sense to spend hours and hours analyzing economic data and financial reports because whatever information you might find, good or bad, has already been absorbed by the market and imbedded in current prices.
3. The strong form of the EMH holds that current market prices reflect all relevant information, whether publicly available or privately held. If this form holds, then even investors with “inside information,” such as corporate officers, would find it impossible to earn abnormal returns—that is, returns in excess of that justified by the riskiness of the investment.