I find the efficient market hypothesis (EMH) to be true but often taken too far. EMH is a finance theory widely taught in academia. It states that security prices reflect all publicly available information very quickly, making it nearly impossible for investors to earn above-average returns consistently.
Note: Several of my descriptions of EMH below come from Burton Malkiel’s book, A Random Walk Down Wall Street. It is one of my favorite books and I recommend it to anyone with an interest in the stock market.
There are two fundamental tenets that make up EMH. Tenet #1: Public information gets reflected in stock prices without delay. Tenet #2: In an efficient market, there are no possibilities for earning extraordinary gains without taking on extraordinary risks.
There’s no doubt that information is incorporated into market prices quickly. Tenet #2 is what I think gets taken too far by the extremists. EMH is most appropriately thought about in terms of relative efficiency driven by stiff competition.
“In an efficient market, competition will ensure that opportunities for extraordinary risk-adjusted gain will not persist.”
“It is possible that the stock market could fail fully to reflect some news event…Therefore, it is probably useful to think of the stock market in terms of “relative” rather than absolute efficiency…it is unrealistic to require our financial markets to be perfectly efficient in order to accept EMH.”
Burton Malkiel, A Random Walk Down Wall Street
This reasonable understanding of EMH is acceptable and hard to argue with. Extreme EMH—the belief that it’s fully impossible to beat the market—is unreasonable. Extreme EMH believers act like it is a scientific law governing the universe, similar to the law of gravity; like there is some invisible force that prevents one from beating the market. But the reason it is so hard to beat the market is because someone always quickly takes advantage of the mispricing that allows for extraordinary gain. Therefore, someone is always beating the market. It’s just very difficult to beat the market consistently due to stiff competition.
“[Efficient market hypothesis] It’s roughly right. It’s just the very hard form…they believed it was impossible [to beat the market] …they thought efficiency was absolutely inevitable. It was like physics; I call it physics envy. They wanted to make their subject like physics. What kind of a nut would want to make stock markets like physics? It ain’t like physics; it’s more like a mob at a football game.”
Charlie Munger, 2017
While information is incorporated quickly by the markets, it is not always incorporated in a rational way. Humans can be very irrational, especially when money is involved. The human element is a limiting factor to efficiency. Reasonable EMH acknowledges irrational behaviors (overconfidence, bias, herding, loss aversion, etc.) are at play and can cause temporary inefficiencies but posits that arbitragers quickly eliminate the inefficiencies, and even when the market occasionally acts irrational as a whole, there are various limits to arbitrage that make it hard to profit off of these inefficiencies.
Active investors are necessary for the market to function properly. Without them, we would have a disaster on hand. The stock market would not accurately reflect information, stocks would not be priced appropriately based on company fundamentals, capital would not be allocated to the best companies, and the market would become illiquid. In this regard, not only is extreme EMH unreasonable and self-defeating, it’s also destructive by discouraging active investment strategies. I believe academic institutions should be teaching the next generation of financial professionals the skills required to value stocks and keep the markets efficient, while also emphasizing how competitive markets are and how hard the task at hand will be.
“The paradox of index investing is that the stock market needs some active traders who analyze and act on new information so that stocks are efficiently priced and sufficiently liquid for investors to be able to buy and sell. Active traders play a positive role in determining security prices and how capital is allocated. This is the main logical pillar on which the efficient-market theory rests.”
Burton Malkiel
I believe markets are mostly efficient, EMH is true, and index investing is the way to go for individual investors. I just don’t subscribe to extreme EMH. I believe some people can beat the market through a combination of skill and luck. EMH believers should shun the extremists, drop the notion of it being impossible, and focus on the idea that it’s extremely difficult due to competition. This would make the theory bulletproof.
“To me it’s almost self-evident…the market is generally, fairly efficient.”
Warren Buffett, 1997
“Hard form efficient market theorists—they’re an embarrassment to the scene…The people who think the market is reasonably efficient or roughly efficient are absolutely correct.”
Charlie Munger, 1997
However, you do not have to accept EMH to accept the benefit of index funds. Warren Buffett regularly recommends index funds for most investors. Many other professionals such as Charlie Munger, Peter Lynch, and Benjamin Graham do or did (if now deceased) acknowledge the benefits of index funds, despite being successful, active investors.
“No matter how efficient or inefficient markets may be, the returns earned by investors as a group must fall short of the market returns by precisely the amount of the aggregate costs they incur. It is the central fact of investing.”
John Bogle
“We can acknowledge the effectiveness of index funds-known as passive investments…without subscribing either to the idea that the price Mr. Market offers for a security is always the best measure of its fundamental value or that no investment approaches will outperform a passive approach over time.”
Bruce Greenwald
“The occasional craziness of market prices makes a belief in EMH (even in relative efficiency) hard for many people to accept. But even nonbelievers should embrace index funds as optimal portfolio investments. Index funds should continue to outperform actively managed funds even if markets are inefficient.”
Burton Malkiel
Here’s a joke to differentiate the extreme EMH believer from the reasonable EMH believer:
An extreme EMH finance professor was walking with a student, when the student pointed out a $100 bill lying on the sidewalk. The extreme EMH professor tells him, “Don’t bother picking it up; if it were really a $100 bill, someone would have picked it up already.” A reasonable EMH finance professor would have told the student, “You better hurry and pick it up before someone else does.”
Bryant Quick 