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Efficient-Market Hypothesis – Are You a Believer?

by Darwin on January 24, 2011

Efficient Market Hypothesis will be this week’s MBA Monday topic (check out that category for everything from Present Value of Money to Tax Shields).  The premise of the Efficient Market is relatively straightforward, but like many economic theories, there are varying levels of degree you can take it too, complex studies and results abound, and at the end of the day, people are generally mixed on whether they believe or adhere to the fundamentals.

What is the Efficient Market Hypothesis?

The premise of the Efficient Market Hypothesis is that markets and participants are at all times on a level playing field with respect to information.  As such, no one person, trader, investor, speculator, whatever…has an edge over anyone else and thus, nobody should ever be able to “beat the market” over an extended period of time for any reason other than shear luck.

The implications of this theory are rather drastic.  For one, it would posit that you should never buy or trade stocks individually – since you have reason to believe your investment strategy should outperform a monkey throwing darts at a stock section of a newspaper.  Next, there’s no such thing as “value investing”.  If you think a stock a trading at a discount to its intrinsic value, you’re wrong – the market is already pricing in the stock’s current valuation.

Digging Deeper into Efficient Market Hypothesis

Taking the research a bit further, there are different “types” of scenarios which manifest themselves:

  • Weak -Weak is primarily aligned with what I described above, where all information on stocks, bonds, commodities and other asset classes are already factoring in all PAST publicly available information.
  • Semi-Strong -This scenario believes further, that this public information pricing is immediately instantaneous.  This notion is further bolstered by the advent of the internet and instantaneous information.  Basically, as soon as any material information is disseminated, it is immediately digested by the masses and instantaneously reflect in the share price of publicly traded companies.
  • Strong -Strong stretches the theory to the brink, saying not only are the above true, but even insider information that most of the trading public is NOT privy to – is already reflected in market pricing.

Efficient Market Theory Examples and Contradictions

Some common examples demonstrating the validity of efficient market theory might be the commonly known phenomena that even most professional money managers cannot beat the returns of their benchmark index over long periods of time.  This tends to demonstrate that if these seasoned professionals who derive a living solely from understanding and investing in the market can’t beat an index, nobody can – because every time they buy or sell a stock, the proper price was already reflected.

A common contradiction to the theory is the bubble and collapse phenomena we’ve grown to know all too well.  How could housing have run up double digits for years, then collapsed precipitously in an unprecedented fashion?  How could some of the world’s largest, most profitable, and top-performing equities have collapsed into bankruptcy, takeovers and government assistance virtually overnight?  Surely, when individual equities are bouncing 20-30% overnight, information was not accurately factored into the share price the day before, right?  Some would explain this as market-panic, herding, and other anomalous behavior that overrides known information or conventional market behavior.  Others would simply point to this as a contradiction of the theory.

Additionally, some investors (these days, often hedge fund managers) have been shown to consistently beat the market.  They do, however, often employ exotic investment strategies, have access to private companies (see how to invest in Facebook, Twitter and Groupon) and other instruments not available to the general public.  But there are some known value investors and “special situation” investors, arbitrageurs and other specialists that actually DO beat the market.  So, perhaps if the semi-strong hypothesis is in play and they’re getting insider information, perhaps that explains it.  Otherwise, they ARE actually beating the market based on THEIR assessment of market valuations.

As individual investors, we often tend to think we’re smarter than the next guy.  This is confirmation bias.  Admittedly, I tend to ride high and use my wins and confirmation of my market prowess, while sticking losses somewhere in the back of my mind.  Buying Apple during the financial collapse was genius.  Selling it along the way so I only have 14 shares left now?  Not so genius (I’d be worth another $10,000 today if I just held all shares and sold last week).  So, the truth is likely somewhere in between.  I do trade individual stocks, but not as much as I used to.  I rely more on ETFs, actual strategies for special situations and arbitrage (see this gold pairs trade – easy money), and stock options (200% gain overnight).  I like to think I’m a better stock-picker than the next guy, but frankly, most of my alpha has come from the non-stock trades of the type cited above.

Are you a Believer?

{ 18 comments… read them below or add one }

101 Centavos January 24, 2011 at 9:04 am

If the market were efficient, then this other old saw would not be valid “Markets can stay irrational longer than you can stay solvent”

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JT McGee January 24, 2011 at 10:06 am

No, I’m not a subscriber.

The markets are “efficient” because others are correcting inefficiencies. The redemption and creation process for exchange-traded funds is a great example here. Around the clock, investment banks/traders redeem and create new ETF shares to moderate the current market price to the Net Asset Value.

These inefficiencies happen in the long-term as well, the problem is, you usually have to wait for near-catastrophic events to find long-term value.

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Darwin January 24, 2011 at 10:26 pm

I sure viewed the March 09 collapse as non-efficient. Mass liquidations were occurring and correlations broke down. I guess that’s the “panic” exception – but I benefited from it bigtime!

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Investor Junkie January 24, 2011 at 3:53 pm

Inefficient short term, efficient long term. Mr. Market from value investing IMHO describes this perfectly.

Short term can mean, days, weeks, months and in some cases years.

The other issue is while the short term market is inefficient there’s friction that can affect your personal return. Taxes and fees.

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Darwin January 24, 2011 at 10:27 pm

Yup, taxes and fees would tend to wipe out any minuscule gains one could conjure up year after year. I’ve got to look at all my trades at the end of this year and see how I stacked up. Seems like I’m way ahead, but I have old gains from prior year entries mixed in. Tax time may be illuminating.

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Rob Bennett January 24, 2011 at 6:42 pm

I view the Efficient Market Theory (and the Buy-and-Hold investing strategy that follows from it) as the biggest mistake ever made in the history of personal finance. I believe that the promotion of Buy-and-Hold was the primary cause of the economic crisis (because it encouraged investors not to sell even when stock prices went to insanely dangerous levels and thereby caused huge losses for millions).

That said, I view the EMT as a huge step forward in our understanding of how markets work. The flaw is the failure to include an adjustment for valuations when determining the stock price. Overvaluation is by definition a mispricing. So obviously the extent of overpricing is never included in the nominal price. Add in an adjustment for the extent of overvaluation (or undervaluation) and you have the true market price.

That true price is efficient. That’s the price that tells us what the market believes the price really should be. You can’t leave out the extent of market irrationality (all overvaluation is irrational, by definition) when reporting what the market says the true price is. A funny way of saying it is: It’s not rational to leave out irrationality!

Rob

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Darwin January 24, 2011 at 10:27 pm

I like your closing line. That just about says it all!

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retirebyforty January 25, 2011 at 5:06 pm

Thanks for the explanation. I like MBA Mondays. :)
I believe in the efficient market theory in the long term and I am also mostly invested in index funds and ETF. I’ll have to think about what Rob said above though.

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Len Penzo January 25, 2011 at 8:27 pm

Do I think they are they 100 percent efficient? No. But information technology — and the spread of that technology into the hands of more and more people — is making it so they are getting vastly more efficient as time moves on!

All the best,

Len
Len Penzo dot Com

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Barb Friedberg January 26, 2011 at 1:58 am

It is generally accepted that the semi strong form of efficiency prevails. I happen to believe that in general it is difficult to beat the market OVER THE LONG TERM. That said, the small stock and value stock anomalies are worth an attempt to exploit; unless enough investors have already exploited them and then they disappear. I WAS THRILLED TO SEE THIS TOPIC. One could discuss it’s pros and cons for a long time. But the empirical literature is still supporting this theory :) Thanks for a great article.

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Invest It Wisely February 2, 2011 at 11:32 am

I believe that they’re efficient in the sense that the market reflects the common knowledge or wisdom held at the time. Now is it possible for lots of people to be wrong about that knowledge? For sure. Take the tech bubble for instance. Is it possible for the market to be distorted? For sure. Look at the impacts of various regulations, laws, and money creation schemes.

However, in the late 90s who could predict exactly when the bubble would burst? Same with the housing bubble… in Canada right now lots of people are pointing to a bubble but I won’t bet on anyone who calls the date or whether it will burst at all.

In one sense it was perfectly rational for people to continue to swap out in the hopes that there would be a bigger sucker down the line. Lots of people lost money but I’m sure lots of people made money as well. I don’t believe that markets act perfectly and never make mistakes; they are composed of humans after all. Nonetheless, the market is very efficient at taking the knowledge and beliefs that people are aware of at the time and transforming them into prices.

I guess a way to summarize it is that one shouldn’t equate “rational” with “logical”. If you equate “rational” with “what makes sense to people and what they believe” then the idea of an efficient market with irrational people makes more sense.

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Invest It Wisely February 2, 2011 at 11:34 am

To clarify my last “irrational” I mean the term as it’s commonly understood by people, not as how I just redefined it.

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George February 2, 2011 at 6:51 pm

If one owns an investment, then one should have a stop loss in place. It doesn’t have to be an automatic stop loss, merely something that you set in your mind. This is the best protection against bubbles being popped and other mispricing.

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Darwin February 5, 2011 at 9:38 pm

I used to be a believer in stop-losses until the flash crash. People were burned big-time there. And if they’re not automated, then during a future flash crash without the rebound, investors will be left with the cratering positions.

I personally don’t use them because I tend to be a longer-term investor who mixed options strategies for shorter term trading, but for others, they may make sense. Double edged sword though.

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nemo February 5, 2011 at 5:09 am

I think the market is very efficient. Efficient, that is, in enriching smooth talking charlatans in sharp suits. If you read Graham & Dodd, that’s all you really need. Don’t waste your money on option trading ‘strategies’ and other nonsense like that.

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Darwin February 5, 2011 at 9:37 pm

How are options strategies nonsense? In an efficient market, options prices are determed similarly to stocks, bonds or any other asset with fluctuating prices. Is it just because you don’t understand how options work?

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Lumpr February 5, 2011 at 11:12 am

“The premise of the Efficient Market Hypothesis is that markets and participants are at all times on a level playing field with respect to information.” – No, that is not the premise of the EMH.

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Darwin February 5, 2011 at 9:36 pm

Thanks for your insightful reply.

Reply

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