Efficient Market Theory

6th September 2020 0 By indiafreenotes

The efficient market hypothesis (EMH), alternatively known as the efficient market theory, is a hypothesis that states that share prices reflect all information and consistent alpha generation is impossible. According to the EMH, stocks always trade at their fair value on exchanges, making it impossible for investors to purchase undervalued stocks or sell stocks for inflated prices. Therefore, it should be impossible to outperform the overall market through expert stock selection or market timing, and the only way an investor can obtain higher returns is by purchasing riskier investments.

The Efficient Market Hypothesis (EMH) is a controversial theory that states that security prices reflect all available information, making it fruitless to pick stocks (this is, to analyze stock in an attempt to select some that may return more than the rest).

Stock picking takes, in the best of cases, a lot of work to be just feebly fruitful, so there are probably better things to do with our resources

The rationale behind this is that the plentiful well-informed motivated professionals that work in the financial markets allegedly form an efficient system for assigning each security the most adequate price, given the available information. Therefore, no individuals can outsmart this fabulous group and beat the marketby regularly buying securities at prices that are lower than what they should be.

Put in other words, the hypothesis is saying that no stock trades too cheaply or too expensively; hence, it would be useless to select which ones to buy or sell. According to the EMH, the reason for this perfect pricing is that, if one stock happens to be trading even just a bit too cheaply (or too costly), then its demand increases (or decreases), rapidly moving the price to its most reasonable value.

This sounds against ordinary wisdom, as we have all heard stories of successful stock picking by keen traders. Sometimes, these traders justify their accomplishments, explaining how they anticipated certain news that produced a change of price, which was unseen for most of the other stock traders. Nevertheless, these cases don’t necessarily contradict the EMH. When some news triggers a change of value, the previous price may have reflected the amount of probability of the news really happening and the price shift it would produce. There was a probability of the news not happening, and if that had been the case, the price would have shifted in opposite direction. If the EMH happens to be right, those who were lucky to select the right outcome this time, may be unlucky the next.

If we are hiring professionals to do stock picking for us, their fees shouldn’t be too high, because the potential benefits aren’t

To decide if investors can beat the market or not, what we need to know is if their predictions are more often right than wrong (actually, that “more often” should be a weighted average that considers the amount of possible profits and losses). On the one hand, people tend to remember and communicate their success stories more than their failures, especially if they are trying to sell a service. Moreover, among the veteran traders in the markets, there are more who won in the past, because those who lost money were more inclined to finding something else to do with their time and remaining assets. So you will hear a lot of success stories about traders supposedly using their knowledge to beat the market, but that doesn’t necessarily prove the EMH to be wrong.

Forms: Weak, Semi-Strong and Strong EMH

There is scientific evidence to support the EMH. According to some it is conclusive (and so they talk about an Efficient Market Theory) and according to others it is not. In part, it depends on the flavor of EMH being under study, as there are three versions of it, which differ in their definition of available information. We said that the hypothesis states that this fabulous team called the market assigns the more adequate price given a certain information. It is key to know what kind of information that is, because if we had more than that data then the EMH wouldn’t say anything about our chances to beat the market.

The EMH version that most interests us (semi-strong) has strong factual support, although it is arguable to say that it is conclusive

The weak version of EMH says that this information is past prices and trading volumes. This type has the strongest support but it is the least significant, as everyone has access to more information than past trading data. For example, company earnings, indebtment, product profile, among other facts (that are called fundamentals). Therefore not much is said about the possibility of investors beating the market or not. Nevertheless, it has an interesting consequence: it would be of no use to perform technical analysis (which is stock price prediction based exclusively on past trading data, in contrast to fundamental analysis, which studies the financial performance of the corporation).

A stronger flavor of EMH, called semi-strong, says that the information in question is all which is publicly available. This version is the most interesting for our case because, as investors, that is exactly the information that we have access to, so if semi-strong EMH is true, then it is useless for us to analyze stock in an attempt to separate winners from losers.

There is a stronger version, or strong EMH, which is based on all information, public or private. This one has evidence against. Therefore, it is illegal to use insider information for trading, as it would mean insiders taking profits from the general public and thus pushing them away from stock trading, something that society doesn’t want. Corporate officers can buy their corporations’ stock, but when they do they have to inform the government, and that information is made public so that their purchase becomes a publicly-known fact.

Implications

The EMH version that most interests us (semi-strong) has strong factual support, although it is arguable to say that it is conclusive. Personally I take it to be not totally true but to a high degree, and that level of acceptance is enough for inferring some important practical conclusions:

  • Stock picking takes, in the best of cases, a lot of work to be just feebly fruitful, so there are probably better things to do with our resources.
  • Instead of picking stocks, it makes sense to buy passively-managed funds with low commissions, such as various ETFs, to obtain the market’s average returns.
  • If we are hiring professionals to do stock picking for us (which happens, for example, when we purchase shares of an actively-managed fund) their fees shouldn’t be too high, because the potential benefits aren’t.
  • Whenever we attempt to beat the market, by performing security picking ourselves or through a professional (fund manager), lets consider the rationale behind the EMH, to identify potential sources of market inefficiency. For example, we better not try to beat the market by analyzing large-cap companies, because lots of people are doing it, with the same information that is available to us. Instead, coming to know a small company and a niche market could put us (or our fund manager) in an advantageous position compared to the rest of the market. Therefore, active management sounds like a better idea for small-cap funds than for large.
  • Don’t feel too bad if you bought a security and then its price fell, you only were as silly (or intelligent) as that fabulous team called the market. There are other better criteria for judging your portfolio-building skills.

Instead of picking stocks, it makes sense to buy passively-managed funds with low commissions, to obtain the market’s average returns

EMH shouldn’t be misinterpreted into thinking that there is no such thing as investment-portfolio design. There are still important decisions to make in order to obtain a portfolio with a risk that suits you; a good (expected) reward for that risk, and the lowest possible costs, meaning commissions and other fees. Modern Portfolio Theory is a set of theories that provide the basis for doing it, with EMH as one of its pillars, and will be treated in subsequent articles. Just as the Efficient-Market Hypothesis, much of the rest of Modern Portfolio Theory is easy to grasp and has immediate practical consequences, even for small investors.