An important debate among investors is whether the stock 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.
Financial theories are subjective. In other words, there are no proven laws in finance. Instead, ideas try to explain how the market works. Here, we take a look at where the efficient market hypothesis has fallen short in terms of explaining the stock market's behavior. While it may be easy to see a number of deficiencies in the theory, it's important to explore its relevance in the modern investing environment.
Tutorial: Behavioral Finance
Efficient Market Hypothesis (EMH) Tenets and Variations
There are three tenets to the efficient market hypothesis: the weak, the semi-strong, and the strong.
The EMH was developed from economist Eugene Fama's Ph.D. dissertation in the 1960s.
The weak makes the assumption that current stock prices reflect all available information. It goes further to say past performance is irrelevant to what the future holds for the stock. Therefore, it assumes that technical analysis can't be used to achieve returns.
The semi-strong form of the theory contends stock prices are factored into all information that is publicly available. Therefore, investors can't use fundamental analysis to beat the market and make significant gains.
In the strong form of the theory, all information—both public and private—are already factored into the stock prices. So it assumes no one has an advantage to the information available, whether that's someone on the inside or out. Therefore, it implies the market is perfect, and making excessive profits from the market is next to impossible.
Problems of EMH
While it may sound great, this theory doesn't come without criticism.
First, the efficient market hypothesis assumes all investors perceive all available information in precisely the same manner. The different 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 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 determine what a stock should be worth under an efficient market.
Proponents of the EMH conclude investors may profit from investing in a low-cost, passive portfolio.
Secondly, no single investor is ever able to attain greater profitability than another with the same amount of invested funds under the efficient market hypothesis. Since they both have the same information, 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 every investor is profitable. But this is far from true.
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 would naturally imply, as many market experts often maintain, the absolute best investment strategy is simply to place all of one's investment funds into an index fund. This would increase or decrease according to the overall level of corporate profitability or losses. But there are many investors who have consistently beaten the market. Warren Buffett is one of those who's managed to outpace the averages year after year.
Qualifying the EMH
Eugene Fama never imagined that his efficient market would be 100% efficient all the time. That would be impossible, as it takes time for stock prices to respond to new information. The efficient hypothesis, however, doesn't 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.
But it's important to ask whether EMH undermines itself by allowing 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's 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.
- The Efficient Market Hypothesis assumes all stocks trade at their fair value.
- The weak tenet of the theory implies stock prices reflect all available information, the semi-strong implies stock prices are factored into all information that is publicly available, and the strong implies all information is already factored into the stock prices.
- The theory assumes it would be impossible to outperform the market and that all investors interpret information the same way.
- Although most decisions are still made by humans, the use of computers to analyze information may be making the theory more relevant.
The Bottom Line
It's safe to say the market is not going to achieve perfect efficiency anytime soon. For greater efficiency to occur, all of these things must happen:
- Universal access to high-speed and advanced systems of pricing analysis.
- A universally accepted analysis system of pricing stocks.
- An absolute absence of human emotion in investment decision-making.
- 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.