EMH is perhaps one of the most fundamental concepts in modern investing and portfolio theory. But what is the Efficient Market Hypothesis? And why is it important?
What Is Efficient Market Hypothesis (EMH)?
Firstly, what exactly is the Efficient Market Hypothesis (EMH)?
To start, it’s a hypothesis. And it’s a hypothesis that’s been tried and tested many a time.
The fundamental idea of the EMH is that all possible inputs that might affect the price of a stock have already been taken into account.
The EMH as we know it today is attributed to a financial economist named Eugene Fama.
Fama (1970) conceptualised and formalised the idea in his seminal paper, Efficient Capital Markets: A Review of Theory and Empirical Work.
Put differently, it’s the idea that stock prices subsume and reflect all available information.
Strictly though, “all” information depends on the strength of the market; specifically, whether it’s “weak”, “semi-strong”, or “strong”. We’ll touch on this later on.
But again, the key idea of the Efficient Market Hypothesis is that stock prices subsume and reflect all available information.
And as a result of this, stocks are therefore fairly priced at all times.
The Efficient Market Hypothesis further says that, because stocks are already fairly priced, it is impossible for investors to consistently generate alpha (outperform the market as a whole).
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Efficient Market Hypothesis and Alpha
The EMH’s stance of it being impossible to consistently generate alpha is perhaps one of the most striking and controversial aspects of the theory.
Indeed, this concept questions the legitimacy and need for fund managers including mutual fund managers, hedge fund managers, etc.
If it’s impossible to consistently generate alpha, then what’s the point of paying hefty fees to fund managers?!
Now, just in case you’re not familar with “alpha”, it represents the return that’s over and above the excess market return.
Put differently, alpha is the technical term to represent “beating the markets”.
Thus, if an investor earns a return that is greater than say, the FTSE100 in the UK or the S&P500 in the US, then she/he has earned alpha.
So, why might hedge funds still be relevant despite the idea that one cannot consistently earn alpha?
Because the keyword here is “consistently“.
It’s About Consistency
The Efficient Market Hypothesis doesn’t say it’s impossible to beat the market.
Rather, it poses – and shows – that it is not possible to consistently beat the market.
The goal of many investors and even hedge funds is to consistently beat the returns of benchmark market portfolios like the S&P500 each year.
And this is where the problem lies.
In order to consistently beat the overall market, one must consistently be able to find stocks that are underpriced and poised to grow.
And they must be capable of doing this every year over the long term.
The Efficient Market Hypothesis would tell us that it is impossible for investors to consistently pick stocks or other assets in such a way that returns are better than the overall market.
The reason is simple.
All information about a particular company that could possibly affect the stock’s price is already available publicly or privately.
This does assume “strong” form efficiency, however. And that doesn’t tend to hold for the most part.
More on that further down.
But even if the “strictest form” of the EMH doesn’t hold, it’s fair to say that most information is already incorporated into the current price of a stock.
This also ties in with the idea that the price of a stock is ultimately based on the Present Value of future expectations.
And since the current market price of a stock already reflects information that’s available to profit from, there’s no room left for us to make a profit!
Okay, now that you know what Efficient Market Hypothesis (EMH) is, let’s think about why it’s important.
Why Is Efficient Market Hypothesis Important?
If it’s impossible for investors to do better than benchmarks, then why bother investing?
The Efficient Market Hypothesis wasn’t meant as a deterrent to investing. Quite the opposite!
The EMH would suggest that the only way for investors to make money consistently over a long period of time is to invest in the whole market.
In other words, according to the Efficient Market Hypothesis, investing in low-cost, broadly diversified, and passively managed index funds are likely the best option.
With the rise of algorithms and computers doing lightning-fast work with information and transactions, this “old” theory of efficient markets might be truer today than it was at its origins.
One might even argue that we’re getting closer and closer to the “strong form” of market efficiency (see further down).
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Importance of the EMH in Shorting
You might be asking several questions now, such as “what about shorting?” or “aren’t there successful traders making millions?”
The EMH applies to shorting a stock since it’s just as difficult to find an overvalued stock to sell short as it is to find an undervalued stock to buy.
It is also true that there are those who seem to be consistently able to return far greater profits than an index fund.
There are also those who lose spectacular amounts of money betting the wrong way.
The Efficient Market Hypothesis takes into account the fact that there are always outliers.
However, the vast majority of investors trying to profit in these seemingly random markets are the focus here.
The Three Types of Efficient Markets
The Efficient Market Hypothesis is sometimes broken down even further by defining three types.
The three types are “weak form EMH,” “semi-strong form EMH,” and “strong form EMH.”
The types (or “forms”) are characterized by the degree to which EMH is applied.
Specifically, they characterise how much and what kind of information is priced into a stock.
- Weak form EMH says that all past prices are shown in the current price of a stock, so something like technical analysis is meaningless. However, fundamental analysis might still be used to find value.
- Semi-strong form EMH says that all public information is already priced into a stock, but non-public information is not. This eliminates both technical analysis and fundamental analysis as methods to find value.
- Strong form EMH is the purest form, stating that all information (public and non-public / private information) is priced into a stock, meaning no amount of analysis can consistently present investors with buying or selling opportunities to beat the market.
The strength (or “forms”) of the markets are relational.
If a market is strong form efficient, it is also semi-strong and weak form efficient.
If on the other hand, a market is semi-strong form efficient, then it is also weak-form efficient. But crucially, it is NOT strong-firm efficient.
Lastly, if a market is weak form efficient, then it is neither semi-strong form efficient nor strong form efficient.
Generally speaking, at least in the context of developed economies, the evidence tends to show that markets are semi-strong form efficient for the most part.
There is often some evidence to show that semi-strong form efficiency is “violated” (meaning it’s not always semi-strong form efficient).
For the most part, at least at the time of writing, there is little evidence to support “strong-form efficiency”.
Critiques of Efficient Market Hypothesis
Efficient Market Hypothesis is technically still ‘just’ a hypothesis, so there are some criticisms.
For instance, if markets were priced accurately at all times, the existence of market bubbles would theoretically be impossible.
It’s important to note that many economists still continue to believe that speculative bubbles don’t exist. One might argue that this is the “economist’s bubble”! 😉
The dot-com bubble of 2001 and the housing market financial crisis bubble of 2008 both potentially serve as evidence that markets are not accurately priced at all times.
There are also very famous investors, such as Warren Buffett, who have consistently chosen stocks that have made them millions or, in Buffett’s case, billions.
However, it’s worth noting that Buffett is the epitome of an outlier. He even advises most people to invest in low-cost total market index funds for the best returns.
And, for the most part, investors who consistently beat the market are few and far between. They’re the exceptions rather than the norm.
As the old saying goes, “if you can’t beat them, join them”.
When it comes to asset allocation then, given the EMH, it’s perhaps best to “join the market” since we can’t really beat it consistently.
What Would An Inefficient Market Look Like?
Efficient Market Hypothesis depends on several critical factors:
- Consistently high liquidity
- Instantaneous information availability
- Low transactions costs
Markets that do not have huge numbers of participants, such as in undeveloped or developing countries, might not be able to support the systems needed to report transactions and convey information as quickly as other markets.
These factors aren’t simply needed for the sake of the Efficient Market Hypothesis – they are needed for any market to operate efficiently.
Stocks might be priced accurately for a majority of the time in developed markets.
But inefficient markets generally don’t convey confidence and could lead to failure of a market in extreme cases.
That being said, it is possible to see instances of somewhat frequent alpha being generated by relying on historic and publicly available information in relatively inefficient markets.
Is EMH Good For Investors?
EMH is not necessarily a “good” or a “bad” thing. Rather, investors should consider it a tool in making investment decisions.
While there are always outliers, understanding Efficient Market Hypothesis can help you feel calm when markets turn sour – as they always do from time to time.
It can also help you feel confident in your return knowing that, although you might not be overperforming (generating alpha, if you will), you’re not underperforming or losing money either.
It’s also important to remember that EMH specifies passive investments are the best for most investors.
An efficient market is certainly good for most people.
If true, the Efficient Market Hypothesis means that people don’t have to spend hours and days researching for the best stock picks.
Because stock performance is both always random and always accurately priced, investors can focus on other things that enrich their lives.
Final Thoughts: The Efficient Market Hypothesis
The Efficient Market Hypothesis is technically just that – a hypothesis.
But it’s a hypothesis that’s been tested repeatedly across the globe and over time.
It suggests that:
- markets are always accurately priced,
- one cannot consistently earn better returns than the overall market by picking specific stocks, and
- passive investment is the only way to guarantee consistent returns (“join” the market rather than trying to beat it)
Naturally, the accuracy of these statements is very much a function of the strength or “form” of the market, including whether it’s:
- weak-form efficient,
- semi-strong form efficient, or
- strong-fom efficient
The stratospheric rise in the amount of money invested in total market funds and ETFs would suggest that many people have started latching onto EMH, whether they know about it or not.
Those who believe the markets are efficiently priced, however, are not short of options.
And they may well end up performing better than if they tried picking stocks themselves.
Importantly, they shouldn’t expect to consistently perform better than the market!
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