An important debate among stock market investors is whether the market is efficient - that is, whether it reflects all the information made available to market participants at any given time. The efficient market hypothesis (EMH) maintains that all stocks are perfectly priced according to their inherent investment properties, the knowledge of which all market participants possess equally. At first glance, it may be easy to see a number of deficiencies in the efficient market theory, created in the 1970s by Eugene Fama. At the same time, however, it's important to explore its relevancy in the modern investing environment. (For background reading, see What Is Market Efficiency?)
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Financial theories are subjective. In other words, there are no proven laws in finance, but rather ideas that try to explain how the market works. Here we'll take a look at where the efficient market theory has fallen short in terms of explaining the stock market's behavior.
EMH Tenets and Problems with EMH
First, the efficient market hypothesis assumes that all investors perceive all available information in precisely the same manner. The numerous methods for analyzing and valuing stocks pose some problems for the validity of the EMH. If one investor looks for undervalued market opportunities while another investor evaluates a stock on the basis of its growth potential, these two investors will already have arrived at a different assessment of the stock's fair market value. Therefore, one argument against the EMH points out that since investors value stocks differently, it is impossible to ascertain what a stock should be worth in an efficient market.
Secondly, under the efficient market hypothesis, no single investor is ever able to attain greater profitability than another with the same amount of invested funds: their equal possession of information means they can only achieve identical returns. But consider the wide range of investment returns attained by the entire universe of investors, investment funds and so forth. If no investor had any clear advantage over another, would there be a range of yearly returns in the mutual fund industry from significant losses to 50% profits, or more? According to the EMH, if one investor is profitable, it means the entire universe of investors is profitable. In reality, this is not the case.
Thirdly (and closely related to the second point), under the efficient market hypothesis, no investor should ever be able to beat the market, or the average annual returns that all investors and funds are able to achieve using their best efforts. This idea would naturally imply, as many market experts often maintain, that the absolute best investment strategy is simply to place all of one's investment funds into an index fund, which would increase or decrease according to the overall level of corporate profitability or losses. There are, however, many examples of investors who have consistently beat the market - you need look no further than Warren Buffett to find an example of someone who's managed to beat the averages year after year. (To learn more about Warren Buffett and his style of investing, see Warren Buffett: How He Does It and The Greatest Investors. For more reading on beating the market, see the frequently asked question What does it mean when people say they "beat the market"? How do they know they've done so?)
Qualifying the EMH
Eugene Fama never imagined that his efficient market would be 100% efficient all the time. Of course, it's impossible for the market to attain full efficiency all the time, as it takes time for stock prices to respond to new information released into the investment community. The efficient hypothesis, however, does not give a strict definition of how much time prices need to revert to fair value. Moreover, under an efficient market, random events are entirely acceptable but will always be ironed out as prices revert to the norm.
It is important to ask whether EMH undermines itself in its allowance for random occurrences or environmental eventualities. There is no doubt that such eventualities must be considered under market efficiency but, by definition, true efficiency accounts for those factors immediately. In other words, prices should respond nearly instantaneously with the release of new information that can be expected to affect a stock's investment characteristics. So, if the EMH allows for inefficiencies, it may have to admit that absolute market efficiency is impossible.
Increasing Market Efficiency?
Although it is relatively easy to pour cold water on the efficient market hypothesis, its relevance may actually be growing. With the rise of computerized systems to analyze stock investments, trades and corporations, investments are becoming increasingly automated on the basis of strict mathematical or fundamental analytical methods. Given the right power and speed, some computers can immediately process any and all available information, and even translate such analysis into an immediate trade execution.
Despite the increasing use of computers, most decision-making is still done by human beings and is therefore subject to human error. Even at an institutional level, the use of analytical machines is anything but universal. While the success of stock market investing is based mostly on the skill of individual or institutional investors, people will continually search for the surefire method of achieving greater returns than the market averages.
If the EMH is accurate, however, it would have the following implications for investors.
EMH and Technical Analysis
Technical analysis bases decisions on past results. EMH, however, believes past results cannot be used to outperform the market. As a result, EMH negates the use of technical analysis as a means to generate investment returns.
With respect to fundamental analysis, the EMH also states that all publicly available information is reflected in security prices and as such, abnormal returns are not achievable through the use of this information. This negates the use of fundamental analysis as a means to generate investment returns.
EMH and the Portfolio Management Process
As we have discussed, the portfolio management process begins with an investment policy statement, including an investor's objectives and constraints. Given EMH, the portfolio management process should not focus on achieving above-average returns for the investor. It should focus purely on risks given that above-average returns are not achievable.
A portfolio manager's goal is to outperform a specific benchmark with specific investment ideas. The EMH implies that this goal is unachievable, and a portfolio manager should not be able to achieve above average returns.
Why Invest in Index Funds?
Given the discussion on the EMH, the overall assumption is that no investor is able to generate an abnormal return in the market. If that is the case, an investor can expect to make a return equal to the market return. An investor should thus focus on the minimizing his costs to invest. To achieve a market rate of return, diversification in a numerous amounts of stocks is required, which may not be an option for a smaller investor. As such, an index fund would be the most appropriate investment vehicle, allowing the investor to achieve the market rate of return in a cost effective manner.
Is The Market Truly Efficient?
It's safe to say the market is not going to achieve perfect efficiency anytime soon. For greater efficiency to occur, the following criteria must be met: (1) universal access to high-speed and advanced systems of pricing analysis, (2) a universally accepted analysis system of pricing stocks, (3) an absolute absence of human emotion in investment decision-making, (4) the willingness of all investors to accept that their returns or losses will be exactly identical to all other market participants. It is hard to imagine even one of these criteria of market efficiency ever being met.
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