Efficient Market Hypothesis (EMH)

The Efficient Market Hypothesis is one of the first things taught in undergraduate economics. It states that at any given time, the price of a stock reflects all available information. This implies that stocks always trade at their fair value, i.e. the price that appropriately takes into consideration every factor that affects it.

The idea is that whenever a piece of information becomes available every participant in the market will buy or sell the stock according to what he or she believes is correct. The price will eventually reach an equilibrium, where the forces of buying and selling are equal. It is not possible to predict an increase (or decrease) in price from the available information - because if you could, every other market participant would buy (or sell) the stock causing the price to rise until no more profit can be derived from it. It is only previously unknowable events, i.e. a new piece of information, that can move price. Price is, therefore, random.

Evidence of the EMH can be found by looking at the performance of active fund managers, i.e. those whose profession is to predict the returns of stocks to outperform the market. According to the S&P 500 Versus Active Funds (SPIVA) report, only 20% of active fund managers have outperformed the market over the last 15 years. Far less than the 50% you would expect from random chance. Additionally, active managers charge high fees for the time and effort they put in, diminishing their returns even further.

In his book, A Random Walk Down Wall Street, Burton Malkiel claimed that “a blindfolded monkey throwing darts at a newspaper's financial pages could select a portfolio that would do just as well as one carefully selected by experts.” This claim was later tested by Rob Arnott of Research Associates, who responded “Malkiel was wrong. The monkeys have done a much better job than both the experts and the stock market.”

Does this mean that all hope is lost?

Contradictions to the EMH

In theory there's no difference between theory and practice, but in practice there is. - Yogi Berra

The “efficient” part of the EMH to the assumptions it makes for its claim to hold.

• Markets are frictionless, i.e. there are no transaction costs involved.
• Information is costless, i.e. it does not cost any time or money to obtain information.
• Investors have homogenous (the same) expectations.
• Investors are rational.

These assumptions clearly apply in a (fictional) perfect world. But in reality, each of them is flawed. Assumption number 4, being that investors are rational, is the big one. Investors are human and, since we do not live in a perfect world, humans are emotional beings.

In Fooled By Randomness, Nicholas Taleb explains a study that was done on patients who had damage to the part of their brain that registers emotion. You would think that without the ability to feel emotion, these patients would be perfectly objective, rational beings. In reality, the subjects in this study were found to be incapable of making decisions altogether, including the decision to simply get out of bed in the morning. This showed that, as humans, it is not possible for us to make a decision completely rationally. That is, without emotion.

We are not capable of conducting the complex calculations necessary to always make the optimal decision. Instead we use heuristics, or mental shortcuts, fueled by emotion to help us overcome our biological disadvantage. If there ever was a completely rational human being, they died long ago because they spent too long assessing the danger when faced with a lion. It was his caveman brother who ran immediately out of fear and survived to pass his genes onto us.

The result of this is that the market experiences bouts of irrationality characterised by increased human emotion. During these periods, the EMH fails and prices deviate from fair value. A famous example of this is the dot-com bubble of the late 1990s. Due to the excitement surrounding the internet investors piled into related stocks, causing massive increases in price. The increases in price attracted more investors who got greedy (an emotional response) and wanted to participate in the returns that their peers were making. They had FOMO! Prices became so disconnected from fair value, that startups with no income would list at astronomical valuations just because they had “.com” in their name.

The dot-com bubble is a glaring contradiction to the EMH. But the EMH is also seemingly contradicted by the level of volatility experienced every day. In a study by renowned economist Robert Shiller, it was found showed that prices fluctuated too much relative to the changes in underlying factors such as earnings or dividends. If you simply observe the market, you will see that stocks can move up and down significantly on a daily basis with no apparent new information to drive the change. Shiller concluded that "the market does not always follow a rational and efficient model, rather it reflects the irrational nature of investors."

Jim Simmons, founder of the Medallion fund, uses mathematical models to find and profit from small price deviations. His fund has significantly outperformed the market since inception, single-handedly disproving the EMH.

Since we are not all mathematicians, another reassuring piece of evidence against the EMH is the existence of Warren Buffett. Warren Buffett has consistently beaten the market since 1965, without a computer, a feat that would not be possible under the EMH other than by random chance. What is his strategy? Buying shares during periods of irrationality.

Be greedy when others are fearful. - Warren Buffett

Most of the time, the market is rational. However, periods of irrationality occassionally present themselves. This is when opportunity arises. You can see Warren Buffett’s strategy in action through the activity statements for his investment firm, Birkshire Hathaway. You can see how his strategy is characterised by long periods of inactivity (when the market is rational) followed by short bursts of buying or selling (when the market is irrational). Most of the time, Warren Buffett does nothing.

So even though the EMH is flawed, it is important to keep in mind because it reminds us what not to do. We do not want to get caught up attempting to predict the market when everything has perfectly been accounted for and it is not possible to profit other than by pure chance. You may as well go to the casino. The only thing we can rely on with certainty, is that humans are emotional. It is that fact that we must use to our advantage if we are to have any hope of beating the market.

What about those active fund managers who make a living from the stock market - if it was that simple to outperform the market, wouldn’t they be the ones to do it? While it sounds simple, putting it into practice is difficult. Periods of irrationality typically involve fear or panic en masse. It hard to be immune against these emotions. Especially when money is involved. Moreover, we are naturally inclined to behave in the same way as our peers, so it is difficult to go against the grain and do the opposite of everyone else. It effects everyone, including professional fund managers, analysts, and commentators.