Roughly Efficient Markets

Introduction

The Efficient Market Hypothesis (EMH) is a foundational concept in finance and is widely taught in academia. At its core, EMH holds that security prices rapidly incorporate all publicly available information, making it extremely difficult for investors to consistently achieve above-average returns. I believe this framework is largely correct but often taken too far.

What EMH Gets Right (and Where It Goes Too Far)

There’s little doubt that new information is incorporated into market prices quickly. The second tenet, however, is where I believe EMH is often taken too far, particularly by its more extreme proponents. Rather than viewing markets as perfectly efficient, EMH is better understood as a framework of relative efficiency, shaped by intense competition among investors.

“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

This more measured interpretation of EMH is reasonable and difficult to dispute. What I find unreasonable is the extreme version of EMH—the belief that it is impossible to beat the market. Taken to that extreme, EMH is treated almost like a law of nature—similar to gravity—as if some invisible force prevents anyone from outperforming.

In reality, the reason beating the market is so difficult is because mispricings are quickly exploited. When an opportunity for extraordinary gain appears, someone takes advantage of it—meaning someone does beat the market. It’s not that outperformance is impossible, but that sustained outperformance is rare due to intense and ongoing competition.

Human Behavior, Active Investors, and Market Efficiency

“[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

While markets incorporate information quickly, they do not always do so rationally. Markets are made up of humans, and humans can be very irrational—especially when money is involved. This human element is a natural constraint on perfect efficiency. A reasonable interpretation of EMH acknowledges that behavioral forces such as overconfidence, bias, herding, and loss aversion can create temporary inefficiencies. At the same time, it recognizes that arbitragers work to exploit and eliminate those inefficiencies, and that even when markets behave irrationally at a broad level, real-world limits to arbitrage often make those opportunities difficult to profit from in practice.

Active investors are essential to a well-functioning market. Without them, prices would not accurately reflect new information, stocks would drift from their underlying fundamentals, capital would be misallocated, and market liquidity would evaporate. In this sense, extreme interpretations of EMH are not only unreasonable, but also self-defeating and potentially harmful—because they discourage the very active investment that keeps markets efficient. Academic institutions should be teaching the next generation of financial professionals how to value businesses and compete in the marketplace, while also emphasizing just how competitive markets are and how difficult consistent outperformance truly is.

“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

Conclusion: Why Index Investing Still Wins

I believe markets are mostly efficient, that EMH is broadly true, and that index investing is the most sensible approach for the vast majority of individual investors. Where I disagree is with extreme interpretations of EMH. I don’t believe market outperformance is impossible—only very difficult. A small number of investors can and do outperform through a combination of skill and luck.

EMH proponents would strengthen the theory by rejecting its most extreme forms and focusing instead on competition as the core constraint. Markets aren’t unbeatable because of some immutable law of nature; they’re difficult to beat because the competition is relentless. Framed this way, EMH becomes both more accurate and more robust.

“To me it’s almost self-evident…the market is generally, fairly efficient.”

Warren Buffett

“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

Importantly, one does not need to fully embrace EMH to appreciate the benefits of index investing. Warren Buffett has long recommended index funds for most investors, and many other legendary investors—including Charlie Munger, Peter Lynch, and Benjamin Graham—have acknowledged their advantages despite achieving success through active management. Their views reinforce a simple truth: recognizing how hard it is to beat the market does not require believing it is impossible.

“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 that illustrates the difference between an extreme and a reasonable interpretation of EMH:

An extreme EMH-minded finance professor was walking with a student when the student pointed out a $100 bill lying on the sidewalk. The professor says, “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, on the other hand, would say, “You better hurry and pick it up before someone else does.”

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