Efficient Market Hypothesis: So Are Markets Efficient?

by Todd Smith on 2010-05-1811

Modern Portfolio Theory (MPT), which is widely used by the financial industry, can serve investors very well. But, as many investors know, MPT has been criticized more vigorously in recent years.

MPT is the model for proper asset allocation and portfolio diversification. By constructing a portfolio of assets that have a low or even negative correlation, an investor can, in theory, reduce overall portfolio risk and maximize returns.

Opponents of MPT cite a few critical errors with this thinking. The technical criticisms include arguments that standard deviation might be the wrong risk measurement, asset correlations are not fixed and change over time, and investor behavior is not rational. But, one of the largest debates is whether financial markets are truly efficient.

efficient market hypothesisImage from StockCharts.com

Efficient Market Hypothesis: So Are Markets Efficient?

The efficient market theory (EMT) suggests that all relevant information is known and factored into the current price of stocks. Not only that, but any new information has been factored into the price before an investor can learn of the information and act on it. So, what the theory has said for years is that there really is no true stock price anomaly that an investor can reasonably take advantage of.

One of my favorite books by Burton Malkiel, A Random Walk Down Wall Street, explains in detail how picking stocks is really no better than chance. He also explains that a random selection of stocks has just the same likelihood of performing well as do stocks picked through research methods or through various techniques used by professional analysts and money managers. So, his contention was that those of us using technical analysis, stock charting tools, etc. are wasting our time. According to Malkiel (and others) — like the founders and proponents of MPT — market inefficiencies don’t exist and you will not be able to use methods to point them out.

But like anything else, there are no absolutes. And to a certain degree, it has to do with your opinion of how efficient the markets are. For instance, how efficient are markets that experience large corrections? If, one could argue, prices are already factored in all relevant information, then how could the stock market experience a large drop like it did in the 80’s, late 90’s, and the most recent bear market?

Efficient Market Hypothesis Categories

Personally, I still agree with Malkiel and others that the markets are pretty efficient. And, in my opinion, even if they are not always perfectly efficient, the average investor like you and me is ill-equipped to take advantage of any anomalies that present themselves. Using the above example, how many people saw large drops in the market ahead of time AND were able to take advantage of it? I’d argue that few people did and the ones who did were lucky. Still, people disagree on how efficient markets may be; these market ideas typically fall into three categories (source: Morningstar.com):

The weak-form EMH tells us that historical information, along with earlier performance is already reflected in the current stock market prices. So basically, the argument here is that technical analysis won’t help you much due to how much it relies on your interpretation of how stock prices are going to behave. But, fundamental analysis may help. Here’s a humorous look at the differences between technical analysis vs fundamental analysis.

The semi-strong EMH form states that both public information as well as historical information are already reflected in current market prices. In this case, investors won’t get much out of fundamental analysis, which requires the study of a company’s fundamentals and financials.

Finally, the strong-form EMH claims that you can’t really use either fundamental analysis nor technical analysis to forecast stock prices because these prices already reflect a whole lot of stuff including public information, historical information AND insider information as well!

Based on my experience, training, and the research I have seen, I personally tend to agree with the semi-strong form of EMH. For instance, I believe that things like fundamental analysis and insider knowledge could help investors. It may seem like a good thing if insider knowledge were public knowledge, but then it would lose its benefit. Also, data I have seen suggests that there are some inefficiencies in international markets and in value stocks that may be able to help investors a bit.

The Influence of EMH

International stocks are less efficient especially in undeveloped and emerging markets. Communication and information is not as quick and forthcoming. However, I am not sure the added political, currency, social risks makes this of much value.

People like Fama and French and others like Berkshire Hathaway have also found that an approach that involves purchasing unloved stocks can result in better returns than if you bought more popular stocks. This value approach may have benefits compared to a growth style. But, historical data over a 100 years tends to suggest that they are fairly equal in performance, just at different times.

Despite the varied EMH criticism, I still am not convinced that average investors or even professional money managers can take advantage of potential anomalies in the markets well enough or consistent enough to make it worth the effort (and usually extra cost). That’s why I prefer an index fund approach. And usually, the empirical data on historical performance backs it up.

Still, even the well known mutual fund Vanguard (which started the index fund trend) recommends a mix of index funds and actively managed funds (they have both). Depending on which form of EMH you believe in, there does seem to be some stock picking techniques that tilt the odds in your favor. Those willing to take a little more risk may look more towards value and international stocks. And those who may think there are drastic inefficiencies in the markets and think they can spot the next correction may think of shorting markets. But, I prefer to do my gambling in Vegas.

Copyright © 2010 The Digerati Life. All Rights Reserved.

{ 11 comments… read them below or add one }

Edwin | Finantage May 18, 2010 at 5:19 pm

I fall into the category of thinking that weak form is the most accurate type of EMH. The true danger of believing in strong form is how it can lead people to adhere to EMH almost religiously. Plenty of evidence shows that strong form is inaccurate yet many people downplay things like bubbles and focus on policies such as extreme deregulation.

Michael Harr @ TodayForward May 18, 2010 at 8:13 pm

One point that is very important to distinguish the variety of EMH views is the mechanism by which inefficiencies are closed. In the strong view, there is no such mechanism as all information is already reflected in the price which is another way of saying the price is always right. Weaker views, however, rely on information gaps as well as these important market hawks that will ‘right-price’ securities. These hawks/smart money/arbitrageurs/give ‘em a name, are typically first movers on information and have large resources for research, analysis, and execution of their strategies.

I like the weaker view because it makes much more sense in light of reality. There have been many, many investors that have beaten the market over the course of long careers. While defenders of the strong view will say that ole Warren has the ability to buy a company and shape its future, he had beaten the market long before he acquired this kind of influence (dollars). The strong view supporters will also claim that these investors are well within the allowable statistical variances.

The bottom line is that the market can be beaten over time, but it requires a great deal of resources that most of us don’t have. As a result, I think Todd’s advice to go with index funds is great for all but the most hard core of investors.

One other thing, this discussion deals with returns. There is a much better case to be made for using active managers to deliver reduced risk over time. While returns on value and growth (in the classical versions rather than the simple split value/growth by p/e down the middle) are similar, risk numbers are considerably different.

Love the topic (because I’m a nerd) and nice job delivering a solid overview.

Rex Huston May 18, 2010 at 9:15 pm

I think that the EMH works is a nice theory, but since humans are involved efficiency is thrown out the window. People are far too emotional. I think 2008 completely disproved the efficient market.

I do believe however that it is important to know and study. You should always be familiar with what theories others in the market are using.

-Rex

Panda mike May 19, 2010 at 7:38 am

I think that the markets is efficient over a long period of time. However, there are several buying opportunities when markets are lead my investors emotions (like what we experience with Greece economic problems right now).

Rob Bennett May 19, 2010 at 12:00 pm

One of my favorite books by Burton Malkiel, A Random Walk Down Wall Street, explains in detail how picking stocks is really no better than chance.

It’s a breakthrough book and it makes a powerful point. But a showing that a monkey throwing darts can pick stocks as effectively as the best-educated investor is not a showing that the market as a whole is efficient.

What Malkiel showed is that stocks are priced properly in relation to each other. If Company A is worth twice what Company B is worth, the capitalization for Company A’s stock will be double the capitalization for Company B’s stock. There is indeed a good deal of evidence showing this to be so.

It does not follow that the market as a whole is priced properly. Company A’s stock could be priced at $30 at a time when Company B’s stock is priced at $15. But if the entire market is priced at three times fair value, you still have a huge problem. The proper price for Company A is $10 and the proper price for Company B is $5. This is where we were in January 2000.

The reason why companies are priced properly in relation to each other is that there is a means (arbitrage transactions) by which those who are aware of mispricings can take advantage of the mispricings and thereby pull prices back to where they should be in relative terms. There is no way to take advantage of mispricings of the entire market (other than to lower your stock allocation until the mispricing is corrected). I know. I checked. If there were a way to take advantage of insane mispricings of the entire market, I would be a very wealthy man today.

It is true that what Malkiel showed argues in favor of indexing,. It does not argue in favor of Buy-and-Hold Investing (staying at the same stock allocation at all price levels). Indexers who stay at the same stock allocation when prices are at insanely dangerous levels (as they were from 1996 through 2008) suffer a wipeout of the accumulated wealth of a lifetime. Investors need to keep their risk levels roughly constant and the riskiness of stocks is far, far greater at times of high valuations.

The people who came up with the Efficient Market Theory were on the right track. But their first-draft attempt at rationalizing the investing project did not stand up to scrutiny. The errors they made were the primary cause of the economic crisis we are living through today. I have hopes that, when these errors are corrected (pray that this happens soon!), we are going to see The Golden Age of Middle-Class Investing.

We’re almost there. But there’s a big difference between an investing approach that almost works and one that really does work.

Rob

Edwin | Finantage May 19, 2010 at 12:57 pm

The act of pricing stocks based on other stocks is what Larry Summers calls “ketchup economics”. Rather than making sure a 2-quart bottle of ketchup is priced properly based on the costs to manufacture it, what people do instead is compare it’s price to the 1-quart bottle. If the 2-quart bottle always sells at double the price of the 1-quart bottle, the markets must be efficient.

This explanation is easy to grasp and points out the absurdity of pricing something compared to something else (be it that a house is priced properly because another in the neighborhood has the same price, or that a stock is priced properly because it’s similar to another stock)

John Hunter May 19, 2010 at 7:23 pm

The markets are moderately efficient in my opinion. But huge amounts of the active cash are controlled by people with an extremely short term focus. This can cause very large distortions that result in a not at all efficient market. There are plenty of corners of the market that are also relatively neglected and where distortions can create value differences. There is also plenty of evidence of how inefficient the markets are. Just look at how poorly it valued mortgage assets in 2003-2007.

Index Investor May 22, 2010 at 8:01 am

I think many of you are mis-interpreting what it means to be “efficient”. From wikipedia, “The efficient-market hypothesis (EMH) asserts that financial markets are “informationally efficient”. That is, one cannot consistently achieve returns in excess of average market returns on a risk-adjusted basis, given the information publicly available at the time the investment is made.”

The key is making “excess returns”. It doesn’t matter if we can identify a bubble in hindsight. The question is, can people do that in a significant manner (i.e., exceeding chance levels) consistently going forward.

Wide swings in asset prices, such as the volatility we’ve seen in the past few years is not evidence that the EMH is false. To prove the EMH wrong, you would need to show that it is possible to get excess returns consistently.

With regards to players such as Buffet beating the market over many years. Yes there are a few but you also have to consider the entire size of the investor population as well (i.e., adjust for what is called multiple hypotheses) — and remember there are millions of people investing. The real question is if markets are so inefficient, why aren’t there more Buffets? Also if you look at Buffets recent performance (past decade), he is a little above the S&P500 but lower than what you would get with a diversified index fund portfolio with similar risk (Buffet is a value investor) based on MPT.

Consumermiser May 24, 2010 at 12:13 am

Whoa, this was a pretty deep and thorough blog post on Efficient Market Hypothesis. Maybe a little too deep, but it’s 3am in the morning for me. I guess I subscribe to the strong-form EMH theory which states that prices reflect not just historical and current publicly available information, but insider information. However, I am an optimist and think there is still something to be gained by investors if they educate themselves about a company, its recent news and future plans.

John Schroy July 27, 2010 at 12:32 pm

Well, I’m sorry, but I subscribe to the inefficient market hypothesis.

The EMH was doubted by many from day one, was never subjected to any scientific scrutiny, and became popular mainly because it pleased economists who believe in market efficiency and rational man.

At its heyday, the EMH fathered the ‘index fund’, on the reasoning that since markets were so efficient (meaning everyone had perfect information and was actually studying the market) it was not longer necessary to manage investments, since prices all reflected intrinsic value. Of course, if everyone was buying an index fund, how could the market be efficient?

Nowadays, the validity of the EMH is seriously doubted. A recent survey of British Chartered Financial Analysts found that 77% no longer believe that investors act rationally.

jeff August 14, 2010 at 12:45 pm

Call me skeptical of any market analysis that leads portfolios on a “buy and hold” mission of doom (last ten years)

I prefer to look for SECULAR TRENDS upon which we can model our approach. Since 2000, when PEs on blue chips were at all-time highs, it did not take an EMH Economist to determine that you should be both “stock-lite” AND tactical, for the upcoming decade. (no EMH economist I know DID provide that advice)

Now we’re in a Secular Debt deflation (see the Great Depression) for a sampling of what THAT playbook looks like…still the EMH’ers don’t think there is any value to such broad macro analysis…so they remain overweighted in stocks and about to relearn Buffets mantra…Don’t lose money.

But what do I know…I don’t have a Nobel Prize, but at least my portfolio is up reasonably for the last ten years.

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