Is the Market Efficient? Understanding the Efficient Market Hypothesis (EMH)

If the world was perfect, it wouldn’t be.” – Yogi Berra


The Efficient Market Hypothesis (EMH) has been widely discussed by many market experts. Understanding it and having an opinion on it is very important for any investor. If you want to develop your own belief about how to invest effectively, having an informed opinion on EMH can be very helpful.

Those who believe in index investing or who market ETF’s are the biggest supporters of EMH, as are most market academics and many newspapers columnists. Most of the top investment managers have specific opinions on EMH and those that beat the indexes over time can almost always tell your why.

EMH has been subject to a lot of hype and marketing. Is the market efficient?

I won’t bore you with an in depth description. The basics, however, are that EMH maintains that all stocks are perfectly priced according to their inherent investment properties, the knowledge of which all market participants possess equally. In other words, there are millions of investors that all have access to all available information about any company and these investors make rational choices of which stocks to buy based on all this available information. Therefore, all stocks are always priced accurately.

When new information becomes available about any company, it is immediately available to all investors who quickly assimilate it with all other information and adjust the stock price accordingly. This means that all stocks are priced correctly all the time and future price movements result from new information that cannot be anticipated from existing known information. Therefore, future price movements are a “random walk”.

The main evidence to support EMH is that most investors do not beat the market. Many studies have shown this. The most popular is usually the Dalbar study that is updated every year. It is now a 20-year study and shows that over the last 20 years, the S&P500 has averaged 13%/year, the average mutual fund (professional investor) has averaged 11%, the average investor (amateur investor) has average 3.5% and the average market timer has averaged a loss of 3.5%. Most of the time, only 20-45% of mutual funds beat their index (depending on which time frame and which index). Clearly, the methods of most investors (professional or amateur) are worse than the market averages.

There are 3 levels of EMH based on the types of information that are fully accounted for in existing share prices:

  1. Weak EMH: All historical market prices and financial data are known to all investors, so no investor can get better returns from analyzing them. This means that all technical analysis (charting) will not work except by luck. Fundamental analysis to figure out the true value of companies can still produce better returns, however.
  2. Semi-strong EMH: All public information about all companies is known to all investors, who are rational and unbiased. This means that fundamental analysis of stocks also cannot produce better returns except by luck. However, insider information or on-site visits could still provide information to produce better returns.
  3. Strong EMH: All public and insider information is known to al investors. Insider information leaks out and laws prevent insiders form using it, so even insider information cannot produce better returns except by luck. Therefore, no strategy or investment method can produce better returns except by luck. A monkey can then pick stocks as well as Warren Buffett.


The big question whenever we hear about any investment strategy or the returns of any investor is: How do you know it is not just luck? EMH claims that future returns from any strategy will fit into a “normal distribution” of possible returns. Whenever you look back, some strategy will have worked better than others, and those that believe in it will claim it was skill (hindsight bias). In fact, since the markets usually rise about 70% of the time, EMH claims that essentially all strategies should work about 70% of the time over the long run.

Market theorists and university professors, of course, tend to believe it, since it is intellectual and relatively simple.

Newspaper columnists often like EMH, usually because it is simple and because it is much more difficult to effectively recommend specific investments. If nobody can beat the market, then the only important factor in investments is the cost of trading or the MER of a fund, which is a very simple concept. Jonathan Chevreau has written hundreds of articles about how nobody can beat the market – so just buy ETF’s.

Professional investors, or course, generally disagree with EMH, since it means that none of them are any better than anyone else. Many dismiss it as ridiculous, but many others have very valid criticisms.

Many amateur investors don’t believe in EMH, usually because of a lack of understanding about it. Most people think they are smarter than average and better investors (and drivers) than average, while EMH claims that the only reason anyone gets better returns is dumb luck. Folklore about the amazing returns of some amateur investor and dreams of making big money fuel this. “If Joe’s brother-in-law can do it, then I so can I…”

Many amateur investors (if they know about EMH) often falsely believe that  EMH means the current price of a stock reflects the future returns that stock will actually make. EMH does not claim that all future information is built into existing stock prices. It claims the likelihoods of all possible future outcomes are taken into account in current share prices. EMH also does not claim that investors act randomly – only that share prices move randomly since they result only from investors reacting to new information as it becomes available. This new information could be about the company, the market, the economy, political events or anything else that might affect the value of a company’s shares and cannot be anticipated.

What do you think – are markets efficient? Is all information available to all investors? Do investors actually access this information and understand it before making investment decisions? Are investors rational? (By the way, if you really understand EMH, I doubt you will either dismiss it completely or believe it completely.)


Arguments For and Against

Let’s take a closer look at the Efficient Market Hypothesis (EMH). Are the markets efficient?

Many amateur and even professional investors dismiss it quickly, but it is clear there is evidence that the stock markets are relatively efficient. As mentioned in part 1, professional and amateur investors usually make considerable less than the markets.

When there is a takeover offer for a company, the price of that company’s shares almost immediately reflect the takeover price (less an amount because of the time until the takeover happens and less the degree of doubt as to whether the takeover will happen). This price adjustment shows market efficiency.

On the other hand, there is also clear evidence that EMH is not totally true. Index enthusiasts argue that all information is available to all investors and that they have rationally built it into the current share price. Therefore, the extreme belief would mean that throwing a dart at the stock page will be equally effective to all investment strategies. Their argument for owning the index is that you own “all of the market” (which is not really true), but their real belief is that any stock would be expected to have the same returns as the index (taking into account the risk level).

If you meet an EMH fanatic, just suggest that they throw a handful of darts at the stock pages instead of buying an index, and you will find they don’t really fully believe in the EMH after all.

The best arguments against the EMH come from the field of behavioural finance. EMH cannot explain market manias. It believes that all investors are always rational, but there have been many examples in history of “irrational exuberance” or irrational pessimism.

For example, the crash of 1987 saw the markets drop by more than 20% in a few days with little news. Seeing the large drops, investors dumped their stocks in panic selling. If you believe an investment is fairly valued, then how can you argue that panic selling as it falls is rational behaviour?

Here in Brampton, we saw our local company Nortel fall from $123.50/share to $.69/share in just over 2 years. EMH would argue that both prices were accurate based on known information. How can that possibly be? In hindsight, it is clear that it was never worth anywhere close to $123.50. This was part of the “tech bubble” with investors having piled into Nortel for a few years only because it was going up as it continued to rise and outperform almost all other investments. And $.69/share was equally ridiculous, with investors finally capitulating and dumping Nortel in mass.

Behavioural finance shows that many cognitive and emotional biases often result in prices selling for much higher or lower than they are really worth. As humans, our minds search for patterns and we see all kinds of patterns that don’t actually exist (clustering bias). We tend to be over-confident, anchor on past numbers, interpret data based on our preconceived views, feel safer following the herd, see things differently in hind-sight and fall prey to many other cognitive biases. (It is worth reading about behavioural finance, because then you will find listening to your investing buddies quite funny! People hate it when you name their investing cognitive bias!)

Humans also tend to often make decisions for emotional reasons. How often have you heard someone say they bought an investment because a “gut feeling” or “it feels right”? Is this rational behaviour? Irrational exuberance and panic selling are clearly emotional reactions and not rational behaviour, as EMH would argue.

The other big argument against EMH is the investors that beat the indexes by wide margins over long periods of time. EMH does claim, however, that by luck and with a normal distribution, a few investors would beat the markets by wide margins over long periods of time.

It is hard to put much faith in claims of spectacular returns by some amateur investors. They can usually not be independently verified, and studies show most amateur investors vastly miscalculate their own returns (if they calculate them at all). In addition, it is very difficult to find evidence that it was not just luck.

However, there are quite a few examples of professional fund managers beating the indexes by wide margins over long periods of time.  Investors such as Warren Buffett, George Soros, Peter Lynch and Bill Miller have beaten the markets by such wide margins over long periods of time that the odds of it being luck are astronomical. These returns are verifiable public information.

There are also quite a few exceptional long term value investors. Value stocks and growth stocks tend to have similar long term returns, with each having their periods in favour. We recently had growth trounce value from 1995-99 so that all value style investments seemed boring and everyone wanted tech and all the high growth sectors. From 2000-2006, value has totally dominated so much that growth investing seems ridiculous and everyone wants resources, cyclicals, financials and dividend stocks. Now in 2007, it appears that growth is starting to take over again.

Value and growth have their cycles and similar long term returns. However, when you look at the long term exceptional investors, they are almost all value investors. For example, Rick Guerin managed the Pacific Partners fund from 1965 to 1983 (19 years) and averaged 32.9%/year while the S&P500 index made only 7.8%. He beat the index by more than 25%/year! Then there were Walter Schloss, Tweedy Browne, Charles Munger, Bill Ruane and quite a few more recent fund managers.

The unique point here is that all these managers are value style. The other 2 main investing styles, growth and momentum, rarely have a manager with long term large index-beating returns. This fact would seem to point to a systematic market inefficiency. The EMH cannot explain it.


My Humble Opinion

My opinions about the Efficient Market Hypothesis (EMH) are not necessarily worth more than anyone else’s, but I have been reading and researching EMH for years. I’ve also heard many informed opinions about it.

I would have to say I believe in the “Weak EMH”. Why?

There is a lot of evidence that markets are relatively efficient and assimilate new information very quickly and usually effectively. EMH cannot be dismissed completely.

However, while most information is available to everyone, most investors make investment decisions based on very little information (such as just recent returns) and often make their decisions primarily on emotional factors. The cognitive errors outlined in behavioural finance explain much of what really happens in the markets. Even professional investors are still human and also fall into these same traps.

Weak EMH claims that all technical analysis (charting) does not work except by luck. I believe that this is true for the most part. We’ve seen many people selling charting strategies, but have seen very few verifiable examples of anyone making a good return from them.

I think that someone sees a pattern that probably does not actually exist. Most patterns we see as humans don’t actually exist. Random stock movements will usually look like a pattern when you study them. Then a bunch investors start to see it and invest by it, which makes the pattern actually happen. Then more people find out about it and recognize the pattern and buy more quickly, which makes the pattern stops working. Once it stops working, then someone who saw it work for a bit starts to market it. (If it worked very well, nobody would market it. They would keep it to themselves.)

From what we’ve seen, the next level of “Semi-strong EMH” is doubtful. It would claim that fundamental analysis does not work, but we’ve seen too many examples of fundamental analysis working. All the exceptional fund managers mentioned in part 2 use fundamental analysis as part of their value style of investing. They study a company to figure out what it is really worth and only buy when they can get it 30-50% below that value.

Part of what we do as financial advisors is to constantly evaluate mutual and hedge fund managers to identify the very best and smartest for our clients. One of the most informative pieces of info is what a fund manager thinks of EMH. Fund managers that beat the index often have very insightful opinions on why they beat the index. Of course, many don’t or have opinions that probably come from something they read. Fund managers that don’t beat the indexes often dismiss EMH or claim the indexes are too risky for their investors.

For example, one of our fund managers is a value style investor that claims most stocks are mispriced most of the time. They work out what companies are really worth and claim most stocks sell noticeably above or below their real intrinsic value. They claim that the market tends to value currently popular companies well, but stocks that are out of favour often sell for much less than they are worth. This is a systematic market inefficiency that they claim to be able to take advantage of consistently (and their performance backs this up).

Another of our fund managers believes the market indexes are really a mutual fund run with specific principles. The index buys large liquid companies, has very little turnover, and dumps its losers and holds its winners – all of which generally work. Most mutual fund managers do the opposite of these. However, the indexes do very little research and so they often own bad or inferior companies. This fund manager systematically beats the indexes by doing what indexes do right and not what they do wrong.

Another fund manager believes there are many, many markets – not just one. Different markets are efficient to different degrees. The US has the most efficient stock market, with many other countries, especially emerging markets being much less efficient. Large cap stocks tend to be more closely followed and so are more efficient than small cap stocks. IPO’s are usually heavily marketed and there is usually less info than with established companies, so IPO’s are less efficient than the broad stock markets. This fund manager beats the indexes by buying undervalued companies and focusing on less efficient markets.

Top fund managers often have these types of profound insights into the EMH and the systematic inefficiency that allows them to beat the index. This is why I don’t believe the “Semi-strong EMH” or “Strong EMH”. Fundamental analysis of stocks quite often produces better returns – much less than half the time but enough to prove it can be systematically done.

Much of the time, top performers were just lucky or their style just happened to be in favour, as EMH claims. However, a few skilled investors can identify and take advantage of systematic inefficiencies in the markets and are disciplined enough to take advantage of them.

Now that you have a general understanding and possibly an opinion on EMH, how does this affect your philosophy about how to invest effectively?

Understand what your opinion about EMH means about how effective different strategies are. For example, does your opinion mean technical analysis (charting) is worth doing? If not, don’t waste your time doing it. Does it mean the fundamental analysis can outperform? Then do much more analysis before buying.

EMH supports index investing (or any low cost diversified investment). How can we use this effectively?

Very few advisors take the time to measure their performance at all, but it is worth doing. Even more, one of the best investment steps you can take is to measure your performance against a benchmark, regardless of your opinion about EMH.

Here is my advice. Whatever your strategy, choose a combination of indexes that you think best approximates your strategy. Make this your personal Benchmark. For example, it could be 30% TSX, 30% Scotia Bond Universe, 20% S&P500 and 20% MSCI World. Then calculate your returns vs. this index combination. This will tell you what benefit you get from your active management. If you are not beating your comparable benchmark over longer periods of time, make sure you understand why – and rethink your investment strategy. Perhaps you should be investing with indexes or with someone that does beat the indexes.

But here is the important part. Whenever you are considering a portfolio change, think about how that might affect your returns vs. your benchmark. Doing this will discourage rash, big bets and it will encourage you to remain invested and diversified.



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