Statistical research has shown that stock prices seem to follow a random walk with no discernible predictable patterns that investors can exploit. Such findings now are taken to be evidence of market efficiency, that is, of evidence that market prices reflect all currently available information. Only new information will move stock prices, and this information is equally likely to be good news or bad news.
Market participants distinguish among three forms of the efficient market hypothesis. The weak form asserts that all information to be derived from past stock prices already is reflected in stock prices. The semistrong form claims that all publicly available information is already reflected. The strong form, usually taken only as a straw man, asserts that all information, including inside information, is reflected in prices.
Technical analysis focuses on stock price patterns and on proxies for buy or sell pressure in the market. Fundamental analysis focuses on the determinants of the underlying value of the firm, such as current profitability and growth prospects. As both types of analysis are based on public information, neither should generate excess profits if markets are operating efficiently.
Proponents of the efficient market hypothesis often advocate passive as opposed to active investment strategies. The policy of passive investors is to buy and hold a broad-based market index. They expend resources neither on market research nor on frequent purchase and sale of stocks. Passive strategies may be tailored to meet individual investor requirements.
Empirical studies of technical analysis generally do not support the hypothesis that such analysis can generate trading profits. Some patterns are suggestive, but these would be either expensive in terms of trading costs or may be due to time-varying risk premiums. One notable exception to this conclusion is the apparent success of momentum-based strategies over intermediate-term horizons.
Several anomalies regarding fundamental analysis have been uncovered. These include the P/E effect, the small-firm-in-January effect, the neglected-firm effect, post-earnings-announcement price drift, and the book-to-market effect. Whether these anomalies represent market inefficiency or poorly understood risk premiums is still a matter of debate.
Behavioral finance focuses on systematic irrationalities that characterize investor decision making. These "behavioral shortcomings" may be consistent with some of the efficient market anomalies uncovered by several researchers.
By and large, the performance record of professionally managed funds lends little credence to claims that professionals can consistently beat the market.
