Efficient Market Hypothesis: Does It Hold Together?

The Efficient Market Hypothesis, which had its beginnings in the 1960s from Eugene Fama's Ph.D. dissertation, states that at any given time all information about a security has been accounted for in the current price of that security. The logical result of this hypothesis is that securities analysts are unable consistently to pick stocks that produce a return in excess of what is returned by the overall market basket of stocks.

The hypothesis exists in three forms namely weak, semi-strong, and strong. According to the weak efficient market hypothesis, a stock's price already reflects all information contained in its historical prices. This flies in the face of technical analysis. The semi-strong version maintains that all publicly available information is reflected in a stock's current price. This variation is essentially saying that fundamental analysis is a waste of time. And finally, the strong version says that all relevant information, including insider information, is reflected in the stock's price. This version is probably the hardest of the three to accept given that insiders are often accused of making moves before the public.

For the most part, the theory is fairly intuitive. After all, the securities markets attract many intelligent, well-paid, and well-educated investors all of whom are seeking the elusive mispriced security from which a profit can be made. And as the number of players has increased and the rate of information dissemination has accelerated, it stands to reason that the result would be an efficient market.

Some people point to fund owners that have outperformed the market for seemingly long periods of time as proof of inefficiencies. The problem with such arguments is that these successful active managers aren't evaluated in the context of all participants. That is, it is difficult to determine whether the out performance is due to skill as opposed to luck. After all, with thousands of active managers, it's generally accepted just from the rules of probability that some will experience sustained and significant out performance. The challenge then is to identify an outperformer before they achieve their results rather than in hindsight.

One final point I want to make. And this is one I've had fun wrapping my head around. The efficient market hypothesis comes with a paradox. That is, if every investor believed the market was efficient, then the market would not be efficient because no one would analyze securities. This means that it's actually to the advantage of believers in the hypothesis to not try and convince others to jump on the bandwagon. The good news is that no matter how many times the hypothesis is examined, there will always be enough people who feel they possess the right combination of skill and intelligence to outperform everyone else.

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1 Comment

  1. I really like your posts and questions you raise. The analogy I think of is driving in heavy traffic. You can see for a little distance around you and so can all the other drivers. If you try to get ahead of the others, it is unlikely to happen. You must drive much more aggressively than your competitors to get a little bit ahead. In my case it is easy to always be in the wrong lane. This is analogous to technical trading. The fellow with a GPS and radio or smartphone may do a little better by getting off the highway on a side road. He generally knows about the best path (value), but will not know how heavy the traffic is there until he takes the turn to get on.

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