Efficient Market Hypothesis (EMH)
The theory that the market knows more than you do.
#Plain-English Definition
The Efficient Market Hypothesis (EMH) states that at any given moment, the price of an asset (or a prediction market share) already reflects all available information.
If a share for "Biden to win" is trading at 60 cents, EMH argues that this price accounts for every poll, every news article, every rumor, and every insider tip that exists. Therefore, it's impossible to consistently "beat the market" unless you have information that nobody else has (or if you are just lucky).
#Three Forms of EMH
- Weak Form: Prices reflect all past trading data. (Technical analysis doesn't work).
- Semi-Strong Form: Prices reflect all publicly available information. (Reading the news won't give you an edge).
- Strong Form: Prices reflect all information, public and private. (Even insider trading won't work—this is widely considered too extreme to be true).
#Why It Matters for Prediction Markets
Prediction markets are often cited as the closest real-world example of efficient markets. Because they aggregate the views of thousands of motivated traders (who put money where their mouth is), the resulting price is often the single most accurate forecast available.
However, prediction markets are not perfectly efficient. They can be biased by:
- Favorite-Longshot Bias: People overbet longshots (1% chance) and underbet favorites (99% chance).
- Dumb Money: An influx of novice traders can temporarily skew prices away from reality.
- Illiquidity: If there aren't enough traders, the price might not update fast enough to new news.
#Key Takeaways
- EMH suggests the current price is the "best guess" of the collective market.
- If you think the market is wrong, you are betting that you have better information or a better model than the aggregate of all other traders.
- Prediction markets strive for efficiency but often have exploitable inefficiencies due to human psychology and liquidity constraints.