Although the `Efficient Market Hypothesis' (EMH) is a cornerstone of modern financial theory, it is highly controversial and often disputed. It is argued that the EMH, which states that markets are generally both rational and efficient and serve as reasonable leading indicators of economic and corporate developments, is fallacious and is actually a derivative of the perfect competition model of capitalism, hardly based on anything substantial as such. This article focuses on the limitations of EMH and its application in the Indian stock market.

Efficient Market Hypothesis (EMH) is the investment theory which states that it is impossible to `beat the market' because stock market efficiency causes existing share prices to always incorporate and reflect all relevant information. According to EMH, this means that stocks always trade at their fair value on stock exchanges, making it impossible for investors to either purchase undervalued stocks or sell stocks for inflated prices. As such, it should be impossible to outperform the overall market through expert stock selection or market timing, and that the only way an investor can possibly obtain higher returns is by purchasing riskier investments.

Efficient market emerges when new information is quickly incorporated into the price so that price becomes information. In other words, the current market price reflects all available information. Under these conditions the current market price in any financial market could be the best unbiased estimate of the value of the investment.

James Lorie, PhD, a Professor of Business Administration, has defined the efficient security market as follows: "Efficiency means the ability of the capital market to function, so that prices of securities react rapidly to new information. Such efficiency will produce prices that are appropriate in terms of current knowledge and investors will be less likely to make unwise investments." In the above context, what will happen is that market-making mechanism becomes free and unfettered.

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