The Efficient Market Hypothesis (EMH) is the idea that all available information is fully reflected in the price of an asset, such as a stock. Developed in the 1960s by American economist Eugene Fama, the EMH argues that it is impossible for investors to consistently outperform the market as stocks always trade at their fair value. Theoretically, the EMH argues that there is no way to purchase stocks at bargain prices or sell them at inflated prices. The theory states that stock picking is, in essence, a “game of chance.”

The EMH is a highly controversial theory and the debate over its correctness—perhaps the most significant debate in the financial world over the past fifty years —ultimately seeks to prove or disprove the merits of active investment management. If the EMH is proven true, there is no need for active investment management. If the EMH is proven false, professional stock pickers will tout their necessity once and for all. Proponents on both sides — active versus passive management — have compelling points of view. The debate has raged on throughout the decades with no end in sight, pitting two theoretical opinions against each other with no means for actual resolution, with each side providing data and rationale to support its assertions. This “no-clear-winner” outcome is a quandary that plagues many arguments beyond finance – opposing views both possessing supposed facts proving their claims (e.g. climate change or fiscal policy). In such cases, data ironically renders both parties correct and the truth remains forever unknown.

However, modern advancements in the field of neuroscience have enabled the resolution of this great debate over the EMH. Through an understanding of the decision-making process, we can bring an end to the head spinning back-and-forth between dueling data-driven arguments in favor and against the EMH. A clear winner can be declared, and the discussion finally closed.

Emotion: The Key Driver Of Our Decision-Making Process

When anyone makes a decision – large or small – there is emotion involved. Physiologically, the human brain is incapable of making decisions without the involvement of both the cerebral cortex and limbic system. There is some degree of emotion and, therefore, bias inherent in every single decision we make. This existence of emotion in the decision-making process has been proven on an anatomical level and is as scientific as the existence of oxygen (O) in water (H2O). Humans are incredibly emotional animals.

A more tangible example of the presence of emotion in our decision making is heuristics: mental shortcuts we subconsciously employ to enable us to solve problems and make judgments quickly. The “anchoring and adjustment” heuristic, for instance, is the reliance on the first piece of information more heavily than all other information obtained; it is the reason we love sales when shopping – we anchor to the original price and automatically think the reduced price is a great bargain. The “availability” heuristic is the assigning of probabilities based on what comes to mind the easiest; it is the reason people think air travel is less safe immediately following a highly publicized plane crash.

There are many more examples of heuristics in our everyday lives. Our brains are very smart, more so than we imagine, and they consistently utilize mental tricks to save us time by rapidly finding solutions to our problems. However, heuristics make our decision-making process, even more clouded and complicated by bias and emotion.

It is important to note that heuristics and other cognitive biases are not always bad for us, but it is through understanding them that we begin to see emotional decision-making at work in a practical sense.

Examining The EMH Through The Lens Of Neuroscience

Modern advancements in neuroscience have illuminated the presence and power of emotion in human behavior. The application of this enhanced understanding of the anatomical brain and our decision-making process is essential if finance is to mature and the investment management knowledgebase is to continuously improve. We must leverage the truths found in neuroscience to empirically answer previously theoretical questions, such as the debate over the veracity of the EMH.

Any argument for the EMH is rooted in the rational choice theory. In order to believe that all information is reflected in the price of an asset, one makes the assumption (leap) that investors are prudent and logical. But emotion is the antithesis of logic, and humans are innately emotional.

Indeed, emotion is always present in markets, and therefore, efficiency is always absent. Prices cannot accurately reflect information – as the EMH holds – if that information is emotionally influenced and the stock prices themselves determined, at least in part, by emotionally-driven decisions. Perhaps, given the knowledge afforded us by neuroscience, we can now retire the debate on market efficiency and reinvent the acronym as “EMH: Emotional Market Theory."

An acceptance of market emotion does more than refute market efficiency, though this is the natural first application. From there, new questions arise in our attempt to continuously improve finance. After resolving market efficiency, one naturally begins to cast a critical eye on the merits of passive investment management. However, a discussion therein requires deeper consideration of randomness before we assume active management is king.

The Bottom Line

A market that is emotional is indeed inefficient, but an inefficient market is not necessarily one in which stock pickers reign supreme. Are financial markets random? And what can neuroscience contribute to such a conversation? Once we put to rest the debate on market efficiency, we can more properly address these crucial questions. The finance industry has been focused on the debate over market efficiency for far too long. It is a debate that when examined through the lens of neuroscience has a simple and clear resolution.

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