Efficient Market Hypothesis

Regular reader Jordan mentioned he was interested in my personal opinion on what is known as EMH, or Efficient Market Hypothesis. From a 30,000 foot perspective, EMH basically means that the market is efficient enough that it is very hard to outsmart. It doesn’t preclude the notion that people can beat the market, but that outperformance would be attributed to luck as opposed to skill. If you took all investors’ returns and plotted them on a graph, you would have something close to a normal distribution curve. There are three forms of EMH:

Weak Form

Believers in the Weak form believe that past prices have no bearing on future prices, therefore technical analysis is useless. More precisely, any information that could be gleaned from past behaviour is fully reflected in the current price.

Semi-Strong Form

Believers in the Semi-Strong form believe that current prices reflect all past prices, and all publicly available information. Therefore, not only is technical analysis of no use, neither is fundamental analysis. Any new public information made available to the market results in completely random (overall) of the affected stocks.

Strong Form

Believers in the Strong form believe that prices reflect all past prices, all public information, and all insider information. The market is perfectly priced.

My Take

Well, you have to put it into context. The EMH is just a model for trying to explain how prices and markets tend to work – even the person most often credited as the father of the theory will point this out.

No form is right enough in my opinion. They are all too rigid. It’s like someone asking you if you are a liberal or a conservative. I’m liberal about some things, and I’m conservative about other things.  Putting me solely into only one camp wouldn’t describe me. Plus, EMH can fall apart at times. I think what can be taken from EMH is the overall lesson that it’s quite a task to beat the market consistently, or identify the person to do it next.

Equilibrium Markets

I view the market as more dynamic (in a different way than volatility). There is an equilibrium that exists between market efficiency and inefficiency, and that equilibrium point moves. For example, if everyone believed strongly enough in EMH and therefore decided to index in large proportions then the market would lose its efficiency as investors as a whole become “price-takers”. They will just take whatever price is out there because they assume it to always be right. For example if 95% of invested dollars indexed the market then it might be quite easy to build a case for fundamental analysis and stock picking and active management because there are few active players who ultimately dictate prices. In a room of 5 people it is easier to identify the alpha dog. But if 95% of invested dollars were actively invested, the market starts looking pretty efficient as there are millions of educated analysts and investors looking under all the same rocks you are. Now there are a billion people in the room.

I don’t know if we’ll ever get to the point where most of the invested dollars are indexed however.

Beyond the efficiency-inefficiency spectrum, black swan events (1987 and 2008 for example) exist which in hindsight seem clearly irrational.

In the end, I choose to believe the markets are efficient enough most of the time with periods of irrationality and just leave it at that. I find EMH to be a good way of thinking about the markets in an academic way, but we invest in the real world.

Preet Banerjee
Preet Banerjee
...is an independent consultant to the financial services industry and a personal finance commentator. You can learn more about Preet at his personal website and you can click here to follow him on Twitter.
Related Posts
Showing 3 comments
  • Mark Wolfinger

    Preet: What do you think of this statement:

    If a substantial majority of investing dollars were indexed, there could only be two possible outcomes:

    a) With few natural buyers and sellers, markets would be dull and only major news events would change the price of stocks

    b) With so few players making natural trades, the markets would become very volatile. Those few traders would buy and sell to each other, while everyone else stood aside and observed.

    Is this analysis reasonable?

  • Patrick

    Ok, you’ve prompted me to give up on polishing my reasoning, and just post my blog entry on the EMH in its current state. I just don’t seem to have the energy or expertise to get that article to the state I wanted.

  • Preet

    @Mark Wolfinger: I would opt for B. If there were few natural buyers and sellers, I think they would engage in shenanigans because they could move the markets with significance. This would lead to indexers abandoning indexing and hiring some of these guys as managers – thus the equilibrium shifts, theoretically until the advantage is removed.