Efficient market hypothesis – What is it, and does it work?
article by CryptoJelleNL
If you have any type of financial or business background, chances are you've heard about the efficient market hypothesis somewhere during your time in university. Professors seem to love the idea of markets being efficient but rarely are able to explain (let alone prove) the assumption. In today's article, we discuss the efficient market hypothesis, its history, and if it is accurate or not.
What is the efficient market hypothesis?
The Efficient Market Hypothesis (EMH) is a theory that states that an asset's price always reflects all information, and that it is impossible to generate alpha over a longer period of time. According to the theory, financial assets price in any new information rapidly - preventing investors from earning consistent above-average returns.
In other words, the theory assumes that assets always trade at their fair values, and that over- and undervalued assets simply do not exist; which would make it impossible to beat the market by selecting the right investments or timing the market. Instead, the theory suggests investing passively and letting time generate returns for you.
There are three different forms of the efficient market hypothesis. In its weak form, the price of an asset is based purely on publicly available market information. We speak of a semi-strong form of efficient markets when we assume an asset's price reflects both market and non-market information that is publicly available. Finally, the strong form of EMH says that any information, both publicly available and privately available is instantly reflected in the price of an asset.
Critique and support of the efficient market hypothesis
Eugene Fama coined the theory in the 1960s and has since received a wide range of critiques - both from investors and academics.
This makes sense because there are numerous investors who have managed to consistently outperform the market over a long period of time – something the EMH considers impossible. Look at Warren Buffett for example, who has been beating the market for over 50 years!
The success of Buffett and others raises serious questions about the hypothesis, but the theory still has many proponents. After all, only a select few are able to consistently outperform the market over a longer period of time.
Data from Morningstar Inc. shows that in the 10 years that followed June 2009, only 23% of actively managed funds outperformed funds that had a passive approach – suggesting that the theory might hold some truth after all.
How accurate is the efficient market hypothesis?
The discussion remains, how accurate is the efficient market hypothesis? Let's look at a few common arguments and their corresponding counterarguments.
A major critique of EMH is that it fails to account for emotional decision-making – where investors overreact to one event and underreact to another. According to B.G. Malkiel (a well-known proponent of the efficient market hypothesis), an underreaction is just as common as an overreaction, and these events result in continuation and reversal at approximately the same odds as well. Based on this, Malkiel claims that these emotional decisions may just be random events - with no influence on the efficiency of a market.
Another group of EMH critics is momentum investors. They say that efficient markets should have no serial correlations between stock prices - but many examples exist where these correlations were found. With these correlations, patterns may be discovered; which is how momentum investors generate alpha. Proponents of the strategy hold a view that these strategies only work temporarily until the correlation becomes widely accepted or known - at which point the market prices in the information and the effect disappears.
Finally, fundamental analysts use different financial ratios to predict the future performance of stocks and to put together their portfolios. Again, a strategy that should not work in a perfectly efficient market. EMH proponents refute this, saying that while these strategies may work from time to time, they do not provide the edge needed to provide consistent outperformance. According to the hypothesis, the success with these metrics is nothing more than temporary, and it will dissipate when they become widely accepted or known, similar to the counterargument used with momentum investors.
All in all, it seems to me that proponents of the hypothesis themselves have concluded that markets are not as efficient as they might believe. After all, they themselves state that serial correlations and anomalies may temporarily exist - suggesting that markets can at most be efficient in the semi-strong form we discussed earlier.
After all, in a strong form of efficient markets, correlations and anomalies would not exist - but rather reflected into the price of assets as soon as they come to life.
Are markets inefficient, then?
While the markets appear not to be as strongly efficient as Eugene Fama originally believed, they are not necessarily inefficient either. A market becomes inefficient when assets trade at prices that do not reflect their inherent value – which can happen due to many different reasons - such as low liquidity, a lack of participants, information asymmetry, emotions, or even blatant market manipulation.
In essence, most markets display inefficiencies from time to time, which allows traders to derive alpha, and generate positive returns - but they usually revert to a more efficient form later.
Closing Thoughts
All in all, we can conclude that markets are mostly efficient, but display inefficiencies from time to time too. These inefficiencies allow investors and traders to derive alpha, and potentially generate consistent outperformance.
The strongest form of the efficient market hypothesis, where any information is immediately priced into the market has been proven and accepted to be wrong by critics and proponents alike - and these same people seem to agree the market is at least somewhat efficient. After all, if markets were completely inefficient, they would move at random, completely erratically.
It is my opinion that the semi-strong variant of the hypothesis is the most accurate description of the efficiency of markets, where the market prices in information as soon as it is publicly available.
I'm curious to hear what your thoughts on the matter are. Do you take a passive approach, or do you actively try to outperform the market?
Author's Disclaimer: This article is based on my limited knowledge and experience. It has been written for informational purposes only. It should not be construed as investment advice in any shape or form.
Editor's note: CryptoJelleNL provides insights into the cryptocurrency industry. He has been actively participating in financial markets for over 5 years, primarily focusing on long-term investments in both the stock market and crypto. While he watches the returns of those investments roll in, he writes articles for multiple platforms. From now on, he will be contributing his insights for WOO Network as well.
Check out his twitter: twitter.com/cryptojellenl
Source: Malkiel, Burton, G. 2003. "The Efficient Market Hypothesis and Its Critics." Journal of Economic Perspectives, 17 (1):59-82.
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