The Efficient Market Hypothesis
In the late 1960s, the work of financial theorist Eugene Fama and a handful of his contemporaries led to what has come to be known as the efficient market hypothesis (EMH). Over time, three different forms of this hypothesis have evolved.
- Strong Form: The price of a market reflects all relevant information about that market.
- Semi-strong Form: The price of a market reflects all publicly known information about that market.
- Weak Form: The price of a market reflects all prior price information.
In each form, the EMH is grounded on the assumption that market participants move prices to a level reflecting existing information. This article will highlight some of the problems with the EMH and some of its popular corollaries.
Behind the scenes of an efficient market
If the EMH is a correct description of price change, what are the intermediate steps that must happen whenever market prices change? Market participants must:
- Receive relevant information immediately.
- Properly interpret that information.
- Act (trade) immediately on that information to maximize their own profits.
The first of these isn't too far fetched. There is always some delay in information flow, but technology is gradually improving this situation. The second and third items here are another story. When new information becomes available, do all market participants properly evaluate that information so that their actions push prices in the "correct" direction? Not likely. Even if market participants are able to properly interpret new information, they still need to act on that information so as to maximize their own profits. This isn't just unlikely, it's impossible. Not all traders are willing and able to place trades at all times. Mutual fund managers and institutional traders are limited in how and how often they may trade. Private investors will often ignore information rather than admit that their prior predictions were incorrect. Can the sum of inefficient participants be an efficient market?
A hypothesis efficiently ignored
We may disagree with the efficient market hypothesis, but we can't deny its popularity. As well known as the EMH has become, certainly the EMH itself is within the set of information already reflected in market prices. Yet somehow, when the EMH became known information, all of the market participants (who always act to their greatest benefit) didn't stop trading. Why didn't all markets suddenly lose their liquidity? Did market participants properly interpret the EMH to mean that active trading can't be profitable? Did they immediately act on this information by ceasing to trade? Apparently not. Our guess is that the market participants who are able to properly evaluate information properly evaluated the EMH, dismissed it incorrect and continued to trade. Those traders who aren't so adept at evaluating market information probably haven't gotten around to figuring out what the EMH means or what to do about it yet.
Investing in an efficient world
The best known popularizer of the EMH is Burton Malkiel, author of the bestseller A Random Walk Down Wall Street. Despite his steadfast belief in the EMH, Malkiel suggests that buying and holding a US equities index fund, such as one which follows the S&P 500, is a profitable investment strategy. This leaves us to wonder why Malkiel feels safe in saying the S&P 500 is currently below some correct higher future price. Why hasn't the market efficiently moved up to this higher price already?
What if the EMH were correct?
As much as we disagree with the idea that markets are efficient, we have to point out that even the proponents of the EMH have failed to evaluate the implications of their own hypothesis. Any EMH adherent will testify that market efficiency causes prices to move in a random walk, which eliminates the possibility of profitable trading. What the EMH school seems to ignore is that if markets truly did follow a random walk, they would be extremely easy to trade profitably. Our article Implications of a Random Walk provides a set of example trading rules for a random walking price series. As you read the article, bear in mind that we chose our example system for the sake of simplicity. Far better ways of trading random walks are possible. In fact, if the nature of the price distribution is known, nearly any market can be traded profitably whether random walking, trending, mean reverting or something else entirely.
