If you read many books–or academic papers–about investing, you’re bound to run into somebody talking about Efficient Market Theory (aka the Efficient Market Hypothesis).
In short, EMT argues that the hundreds of thousands of investors constantly bidding stock prices upward and downward creates a situation in which, at any given moment, a stock’s price must reflect the sum total of all known information about the company.
Also, given that all known information is already reflected in the stock’s current price, the only thing that can cause a stock’s price to move must be the release of information that was previously unknown.
Implications of EMT
If EMT holds true, there would be several implications for investors:
- Predicting short-term stock movements–or entire market movements–would be impossible because the only thing that would cause a movement is the release of information that was unknown (and therefore unpredictable by definition).
- Beating the index benchmarks would be impossible except through luck (i.e., guessing correctly whether the next release of information would be positive or negative).
- The only reliable ways to increase your return would be to take on more risk (in the technical finance-world sense) and/or reduce your investment costs.
Why it seems to hold up
For the most part, financial markets do seem to be rather efficient. There are very few people who have been able to repeatedly find and exploit inefficiencies in the market.
And even among those investors who have outperformed the market, the majority of them can be explained purely by luck. The number of investors who have outperformed substantially and persistently enough to provide us with statistical confidence that it’s due to skill is very close to zero.
Completely unscientific example: Without doing any Google searching, can you name more than 5 such investors?
My doubts about Efficient Market Theory
On the other hand, I am extremely reluctant to think that every stock–or almost any stock for that matter–is perfectly priced at any given moment. For example, I have a hard time believing that the U.S. economy is in fact worth roughly 40% less than it was worth in the Fall of 2007. I have to suspect that it was either overpriced then, underpriced now, or some combination thereof.
It seems to me that the market does not respond perfectly to new information. Rather, it appears to overreact to information (both good and bad).
What do you think?
In short, I tend to subscribe to a fairly weak version of Efficient Market Theory:
- I’m inclined to think that the market does, in fact, have some anomalies–securities that are either underpriced or overpriced–from time to time.
- However, I have my doubts as to how worthwhile it is to attempt to exploit such anomalies. (If it were so easy to do, why haven’t more fund managers been successful at it over any extended period?)
What do you think about Efficient Market Theory? Do you buy it?
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{ 5 comments }
Some clarifications, the economy is not worth 40% less, large, publicly traded are.
Also, EMT does not assume that at a given moment in time the stock is priced perfect, just that over the long term it is. Perhaps a differences without a distinction, perhaps not.
I’ve struggled with EMT since college, but as of right now I am a believer and dollar cost averaging picks up the slack.
Hi Weakonomist.
You’re right about the publicly traded vs entire economy point. Thank you for pointing that out.
As to what EMT states, my understanding (which could be wrong) is that there are different levels of it, some more strict than others.
My understanding is that the most strict version of EMT states that at every moment each stock is priced to include all known information. (Or at least, the price will reflect the new information within minutes of it being released.)
People are irrational?
Isn’t that the save-all of all economic/game theory?
Your comment includes the fact that EMT addresses the “known knowns”, i.e. all the information that is known. Over the long term, the stock’s price factors in all the information that is known by everybody. All information, however, is not known by any one person at any given point in time. The one person only “knows what he knows” and that includes the stock price. When the stock price is lower or higher than the person’s own information supports, then person “knows there is something he doesn’t know” and may speculate or try to learn what that is. But there is also the “unknown unknowns”. I suspect the “unknown unknowns” are what are keeping the market undervalued compared to last year. For example, until Obama has been in office a while, no one knows proposed price tag(s) nor whether they will pass or not. Or in other words, there is an awful lot of worldwide uncertainty priced into almost every security right now. Just my $1.84 worth.
For me, once I heard of it, given how well passive investing works, the EMH certainly makes sense. From what I’ve read there are various “strengths” of this hypothesis. The practical upshot seems to be that to outperform the market by X, one would have to incur extra expenses (overall) of at least X. Also, obvious WELL DOCUMENTED outliers like Warren Buffett had most of their outperformance before powerful computing technology became commonplace. Technology seems to have raised the difficulty in outperforming in recent decades.
The thing I learned about a while back that suddenly made the EMH make intuitive SENSE is the “Wisdom of Crowds” concept. With the investor universe, you essentially have a “crowd” of everybody, and everybody involved has an extremely strong self interest (profits) in voting correctly – thus, IMO, likely the wisest crowd of all.
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