If I were to choose one thing from the academic world of finance that I think more individual investors need to know about, it would be the efficient market hypothesis.
The name “efficient market hypothesis” sounds terribly arcane. But its significance is huge for investors, and (at a basic level) it’s not very hard to understand.
So what is the efficient market hypothesis (EMH)?
As professor Eugene Fama (the man most often credited as the father of EMH) explains, in an efficient market, “the current price [of an investment] should reflect all available information…so prices should change only based on unexpected new information.”
It’s important to note that, as Fama himself has said, the efficient market hypothesis is a model, not a rule. It describes how markets tend to work. It does not dictate how they must work.
EMH is typically broken down into three forms (weak, semi-strong, and strong) each with their own implications and varying levels of data to back them up.
Weak Efficient Market Hypothesis
The weak form of EMH says that you cannot predict future stock prices on the basis of past stock prices. Weak-form EMH is a shot aimed directly at technical analysis. If past stock prices don’t help to predict future prices, there’s no point in looking at them — no point in trying to discern patterns in stock charts.
From what I’ve seen, most academic studies seem to show that weak-form EMH holds up pretty well. (Take, for example, the recent study which tested over 5,000 technical analysis rules and showed them to be unsuccessful at generating abnormally high returns.)
Semi-Strong Efficient Market Hypothesis
The semi-strong form of EMH says that you cannot use any published information to predict future prices. Semi-strong EMH is a shot aimed at fundamental analysis. If all published information is already reflected in a stock’s price, then there’s nothing to be gained from looking at financial statements or from paying somebody (i.e., a fund manager) to do that for you.
Semi-strong EMH has also held up reasonably well. For example, the number of active fund managers who outperform the market has historically been no more than can be easily attributed to pure randomness.
Semi-strong EMH does not appear to be ironclad, however, as there have been a small handful of investors (e.g., Peter Lynch, Warren Buffet) whose outperformance is of a sufficient degree that it’s extremely difficult to explain as just luck.
The trick, of course, is that it’s nearly impossible to identify such an investor in time to profit from it. You must either:
- Invest with a fund manager after only a few years of outperformance (at which point his/her performance could easily be due to luck), or
- Wait until the manager has provided enough data so that you can be sure that his performance is due to skill (at which point his fund will be sufficiently large that he’ll have trouble outperforming in the future).
Strong Efficient Market Hypothesis
The strong form of EMH says that everything that is knowable — even unpublished information — has already been reflected in present prices. The implication here would be that even if you have some inside information and could legally trade based upon it, you would gain nothing by doing so.
The way I see it, strong-form EMH isn’t terribly relevant to most individual investors, as it’s not too often that we have information not available to the institutional investors.
Why You Should Care About EMH
Given the degree to which they’ve held up, the implications of weak and semi-strong EMH cannot be overstated. In short, the takeaway is that there’s very little evidence indicating that individual investors can do anything better than simply buy & hold a low-cost, diversified portfolio.