The efficient market hypothesis (EMH) is a central topic of debate among investors. It questions whether the stock market is efficient, meaning it reflects all available information to market participants at any given time. According to EMH, all stocks are perfectly priced based on their investment properties, with all market participants having equal knowledge.
Financial theories are subjective, with no proven laws in finance. Instead, they aim to explain market operations. This article examines where EMH falls short in explaining stock market behavior and its relevance in today’s investing environment.
The Efficient Market Hypothesis (EMH) is a theory that posits that it is impossible to ‘beat’ the market because stock market efficiency causes existing share prices to always incorporate and reflect all relevant information. However, there are several arguments against EMH.
Firstly, one argument against EMH is that since investors value stocks differently, it is impossible to determine what a stock should be worth in an efficient market.
Proponents of EMH argue that investors may profit from investing in a low-cost, passive portfolio.Secondly, under the efficient market hypothesis, no single investor is ever able to attain greater profitability than another with the same amount of invested funds. Since they both have the same information, they can only achieve identical returns. However, consider the wide range of investment returns attained by the entire universe of investors, investment funds, and so forth.
If no investor had any clear advantage over another, would there be a range of yearly returns in the mutual fund industry, from significant losses to 50% profits or more? According to EMH, if one investor is profitable, it means every investor is profitable. But this is far from true.Thirdly, and closely related to the second point, under the efficient market hypothesis, no investor should ever be able to beat the market or the average annual returns that all investors and funds are able to achieve using their best efforts.
This would naturally imply, as many market experts often maintain, the absolute best investment strategy is simply to place all of one’s investment funds into an index fund. This would increase or decrease according to the overall level of corporate profitability or losses. But there are many investors who have consistently beaten the market. Warren Buffett is one of those who’s managed to outpace the averages year after year.Qualifying the EMH, Eugene Fama never imagined that his efficient market would be 100% efficient all the time. That would be impossible, as it takes time for stock prices to respond to new information. The efficient hypothesis, however, doesn’t give a strict definition of how much time prices need to revert to fair value. Moreover, under an efficient market, random events are entirely acceptable, but will always be ironed out as prices revert to the norm.
But it’s important to ask whether EMH undermines itself by allowing random occurrences or environmental eventualities. There is no doubt that such eventualities must be considered under market efficiency but, by definition, true efficiency accounts for those factors immediately. In other words, prices should respond nearly instantaneously with the release of new information that can be expected to affect a stock’s investment characteristics.
So, if the EMH allows for inefficiencies, it may have to admit that absolute market efficiency is impossible.Increasing Market Efficiency? Although it’s relatively easy to pour cold water on the efficient market hypothesis, its relevance may actually be growing. With the rise of computerized systems to analyze stock investments, trades, and corporations, investments are becoming increasingly automated on the basis of strict mathematical or fundamental analytical methods.
Given the right power and speed, some computers can immediately process any and all available information, and even translate such analysis into an immediate trade execution.Despite the increasing use of computers, most decision-making is still done by human beings and is therefore subject to human error. This is true even at an institutional level, where the use of analytical machines is not universal.
While the success of stock market investing is based mostly on the skill of individual or institutional investors, people will continually search for the surefire method of achieving greater returns than the market averages. The Bottom Line: It’s safe to say the market is not going to achieve perfect efficiency anytime soon. For greater efficiency to occur, several conditions must be met: 1. Universal access to high-speed and advanced systems of pricing analysis. 2. A universally accepted analysis system of pricing stocks. 3. An absolute absence of human emotion in investment decision-making. 4. The willingness of all investors to accept that their returns or losses will be exactly identical to all other market participants. It is hard to imagine even one of these criteria of market efficiency ever being met.
