The Efficient Market Hypothesis (EMH), also known as the Efficient Market Theory, is an intriguing hypothesis asserting that share prices always incorporate and reflect all available information, making it impossible to consistently generate excess returns—known as alpha—through expert stock selection or market timing.
Key Takeaways
- The EMH states that share prices reflect all known information.
- According to EMH, stocks always trade at their true market value, eliminating opportunities for investors to purchase undervalued stocks or sell shares at inflated prices.
- Proponents of EMH advocate for investing in low-cost, passive portfolios.
- Critics of EMH believe that it is feasible to outperform the market and argue that stocks can deviate significantly from their true value over time.
Understanding the Efficient Market Hypothesis (EMH)
Although the EMH is a cornerstone of modern financial theory, it’s a controversial topic within the financial community. Believers argue that looking for undervalued stocks or forecasting market trends through fundamental or technical analysis is a futile exercise.
Theoretically, not even technical knowledge or fundamental insights can secure risk-adjusted excess returns consistently; only inside information could potentially result in above-market returns.
Historical Example Serves as Reminder
As of February 9, 2024, Berkshire Hathaway Inc. Class A (BRK.A) held the title for the world’s most expensive stock with a share price of $599,090.00.
While academic studies lend robust support to EMH, dissent also has formidable evidence. Notably, Warren Buffett’s history of market outperformance challenges the hypothesis. According to EMH, consistently beating the market, as Buffett has done, should be impossible.
Critics also point to events like the 1987 stock market crash when the Dow Jones Industrial Average (DJIA) plummeted by over 20% in a single day. Such occurrences exemplify markets significantly deviating from their fair values.
Special Considerations
Proponents of EMH maintain that the market’s randomness suggests that investing in a passive, low-cost portfolio may yield better outcomes for the average investor.
Morningstar’s June 2019 Active/Passive Barometer study, which looked at active managers’ performance against a benchmark of index and exchange-traded funds (ETFs), supported EMH. Within a ten-year time frame starting June 2009, only 23% of active managers outperformed their passive counterparts. Higher success rates were found in foreign equity and bond funds, while significantly lower rates were noted among US large-cap funds. This indicates that investing in low-cost index funds or ETFs often provides better returns.
Despite some active managers outperforming at certain points, identifying those who can do so consistently over the long term is difficult. Less than 25% of top-performing active managers consistently outperform their passive counterparts.
What Does It Mean for Markets to Be Efficient?
Market efficiency indicates how well asset prices reflect all available information. The Efficient Market Hypothesis asserts that markets are efficient, leaving next to no room for excess profits through investment since every asset is precisely and fairly priced to account for all known information. This suggests that while market beating may be impossible, achieving market returns via passive index investing is entirely feasible.
Has the Efficient Markets Hypothesis Any Validity?
The EMH’s validity remains a hotly debated issue. Though some have managed to outperform the market, like Warren Buffett through his undervalued stock-focused strategy, EMH proponents argue such outperformance results not from skill but from luck. Given a market with numerous participants, statistical deviations will result in some outperforming while others underperforming, merely by chance.
Can Markets Be Inefficient?
Some markets exhibit less efficiency than others. An inefficient market is one where asset prices do not genuinely reflect their intrinsic values. Such inefficiencies may arise due to information asymmetries, lack of active participants (low liquidity), heightened transaction costs or delays, market psychology, and human emotion, among other reasons. Inefficiencies can often result in economic deadweight losses. Most real-world markets show varying degrees of inefficiencies, and at the extreme, an inefficient market indicates a market failure.
Accepting the pure, or strong, form of EMH might be challenging, as it assumes all information, public or private, is priced into stock values. Modified versions of EMH can account for different degrees of market efficiency:
- Semi-strong efficiency: Claims that all public information is factored into a stock’s current price, rendering both fundamental and technical analysis ineffective for achieving superior gains.
- Weak efficiency: Suggests all past stock prices are integrated into today’s price, thus negating technical analysis as a tool to predict and beat the market.
What Can Make a Market More Efficient?
When more participants engage in a market, that market can become increasingly efficient due to a broader spectrum of information being utilized to derive asset prices. Heightened market activity and liquidity mean the presence of arbitrageurs who quickly correct minor inefficiencies, thus restoring market efficiency.
Related Terms: alpha, market timing, technical analysis, fundamental analysis, Warren Buffett, undervalued stocks, overvalued stocks, index funds, exchange-traded funds, arbitrage.
References
- The Library of Economics and Liberty. “Efficient Capital Markets”.
- Yahoo Finance. “Berkshire Hathaway Inc. (BRK-A)”.
- Federal Reserve History. “Stock Market Crash of 1987”.
- Morningstar. “Active Funds vs. Passive Funds: Which Fund Types Had Increased Success Rates?”
