📈 Efficient-Market Hypothesis (EMH)

Main Topics Covered

Definition of the EMH and what it implies about beating the market
Origins and key figures behind the idea
Theoretical background: arbitrage, the fundamental theorem of asset pricing, random walks and martingales
Empirical studies and the weak, semi-strong and strong forms of efficiency
Criticism: behavioral finance, the joint hypothesis problem, anomalies and the rejection of CAPM
Views of journalists, economists and investors (Buffett, Munger, Malkiel, Lynch, Samuelson and others)
The 2008 financial crisis and the debate it renewed
Use of efficient market theory in securities class action litigation

💡 Core Idea

The efficient-market hypothesis (EMH) is a hypothesis in financial economics that states that asset prices reflect all available information.

A direct implication is that it is impossible to "beat the market" consistently on a risk-adjusted basis, since market prices should only react to new information.
The EMH is formulated in terms of risk adjustment, so it only makes testable predictions when coupled with a particular model of risk.
Because of this, research in financial economics since at least the 1990s has focused on market anomalies, that is, deviations from specific models of risk.

Origins and Importance

The idea that financial market returns are difficult to predict goes back to Bachelier (1900), Mandelbrot (1963), and Samuelson (1965).
It is closely associated with Eugene Fama, in part due to his influential 1970 review of the theoretical and empirical research.
The EMH provides the basic logic for modern risk-based theories of asset prices.
Frameworks such as consumption-based asset pricing and intermediary asset pricing can be thought of as the combination of a model of risk with the EMH.

🧮 Theoretical Background

The Basic Thought Experiment

Suppose a piece of information about the value of a stock (say, about a future merger) is widely available to investors.
If the price does not already reflect that information, investors can trade on it, moving the price until the information is no longer useful for trading.

Efficiency Does Not Mean Unpredictable Prices

Suppose the information says that a financial crisis is likely to come soon.
Investors typically do not like to hold stocks during a financial crisis, so they may sell stocks until the price drops enough that the expected return compensates for this risk.
So the thought experiment does not necessarily imply that stock prices are unpredictable.

Fundamental Theorem of Asset Pricing

How efficient markets are (and are not) linked to the random walk theory can be described through the fundamental theorem of asset pricing.

It gives mathematical predictions about the price of a stock, assuming there is no arbitrage, that is, no risk-free way to trade profitably.
If arbitrage is impossible, the price of a stock is the discounted value of its future price and dividend:

$P_t = E_t\left[M_{t+1}\left(P_{t+1} + D_{t+1}\right)\right]$

Symbol	Meaning
$E_t$	Expected value given information at time $t$
$M_{t+1}$	The stochastic discount factor
$D_{t+1}$	The dividend the stock pays next period

From Pricing Equation to Random Walk

This equation does not generally imply a random walk.
Assume the stochastic discount factor is constant and the time interval is short enough that no dividend is paid:

$P_t = M\,E_t\left[P_{t+1}\right]$

Taking logs and assuming that the Jensen's inequality term is negligible:

$\log P_t = \log M + E_t\left[\log P_{t+1}\right]$

This implies that the log of stock prices follows a random walk (with a drift).

Martingale Comparison

The concept of an efficient market is similar to the assumption that stock prices follow a martingale:

$E\left[S_{t+1} \mid S_t\right] = S_t$

However, the EMH does not always assume that stocks follow a martingale.

🔬 Empirical Studies

Research by Alfred Cowles in the 1930s and 1940s suggested that professional investors were in general unable to outperform the market.
During the 1930s-1950s, empirical studies focused on time-series properties and found that US stock prices and related financial series followed a random walk model in the short-term.
There is some predictability over the long-term, but the extent to which this is due to rational time-varying risk premia as opposed to behavioral reasons is a subject of debate.
A seminal paper proposed the event study methodology and showed that stock prices on average react before a stock split, but have no movement afterwards.

Weak, Semi-Strong, and Strong-Form Tests

In Fama's influential 1970 review paper, he categorized empirical tests of efficiency into three types. These categories refer to the information set used in the statement "prices reflect all available information."

Form of test	Information studied
Weak-form	Information contained in historical prices
Semi-strong form	Information beyond historical prices that is publicly available
Strong-form	Private information

Weak-form tests study the information contained in historical prices. Strong-form tests regard private information.

⚠️ Criticism

Investors, including the likes of Warren Buffett and George Soros, and researchers have disputed the EMH both empirically and theoretically.
Empirical evidence has been mixed, but has generally not supported strong forms of the EMH.
Behavioral economists attribute the imperfections in financial markets to a combination of cognitive biases:
- overconfidence
- overreaction
- representative bias
- information bias
- various other predictable human errors in reasoning and information processing
These have been researched by psychologists such as Daniel Kahneman, Amos Tversky and Paul Slovic and economist Richard Thaler.

The P/E Evidence

According to Dreman and Berry, in a 1995 paper, low P/E (price-to-earnings) stocks have greater returns.
In an earlier paper, Dreman also refuted the assertion by Ray Ball that these higher returns could be attributed to higher beta leading to a failure to correctly risk-adjust returns.
Dreman's research had been accepted by efficient market theorists as explaining the anomaly in neat accordance with modern portfolio theory.

Behavioral Psychology

Behavioral psychology approaches to stock market trading are among the alternatives to the EMH. Investment strategies such as momentum trading seek to exploit exactly such inefficiencies.
Nobel Laureate Daniel Kahneman, however, announced his skepticism of investors beating the market: "They're just not going to do it. It's just not going to happen."

Defenders' Response

Defenders of the EMH maintain that behavioral finance strengthens the case for the EMH, because it highlights biases in individuals and committees and not competitive markets.

Hyperbolic discounting: individuals employ it, but bonds, mortgages, annuities and other similar obligations subject to competitive market forces do not. Any manifestation of it in their pricing would invite arbitrage, quickly eliminating any vestige of individual biases.
Loss aversion: diversification, derivative securities and other hedging strategies assuage if not eliminate potential mispricings from the severe risk-intolerance of individuals.
Economists, behavioral psychologists and mutual fund managers are drawn from the human population and are therefore subject to the biases that behavioralists showcase.

Transaction Costs and Liquidity

Further empirical work highlights the impact of transaction costs on market efficiency.
Much evidence suggests that anomalies pertaining to market inefficiencies are the result of a cost benefit analysis made by those willing to incur the cost of acquiring valuable information in order to trade on it.
Liquidity is a critical component to capturing "inefficiencies" in tests for abnormal returns.

The Joint Hypothesis Problem

Any test of the EMH faces the joint hypothesis problem: it is impossible to ever test for market efficiency, since doing so requires a measuring stick against which abnormal returns are compared.
One cannot know if the market is efficient if one does not know if a model correctly stipulates the required rate of return.
Consequently, either the asset pricing model is incorrect or the market is inefficient, but one has no way of knowing which is the case.

An Odd Correlation

The performance of stock markets is correlated with the amount of sunshine in the city where the main exchange is located.

EMH Anomalies and Rejection of the Capital Asset Pricing Model (CAPM)

Event studies of stock splits are consistent with the EMH, but other empirical analyses have found problems with it.
Early examples: small neglected stocks and stocks with high book-to-market (low price-to-book) ratios (value stocks) tended to achieve abnormally high returns relative to what could be explained by the CAPM.
Further tests of portfolio efficiency by Gibbons, Ross and Shanken (1989) led to rejections of the CAPM, although tests of efficiency inevitably run into the joint hypothesis problem (see Roll's critique).

Move to Risk Factor Models

Following those results and mounting evidence of anomalies, academics began to move away from the CAPM towards risk factor models such as the Fama-French 3 factor model.
These models are not properly founded on economic theory (whereas CAPM is founded on Modern Portfolio Theory), but are constructed with long-short portfolios in response to observed empirical anomalies.
Example: the "small-minus-big" (SMB) factor is simply a portfolio that holds long positions on small stocks and short positions on large stocks to mimic the risks small stocks face.
These factors are said to represent some aspect of undiversifiable systematic risk which should be compensated with higher expected returns.

Factor	Description
SMB	Small-minus-big (size)
HML	Value factor
MOM	Momentum factor
ILLIQ	Liquidity factor

🗣️ Views of Journalists, Economists, and Investors

Closed-End Funds (CEFs)

Several observers have argued that closed-end funds show evidence of market inefficiency.
Mutual funds and exchange traded funds can regularly redeem or create new shares and tend to trade very close to net asset value (NAV).
CEFs raise capital by issuing a fixed number of shares at inception and are closed to new capital afterwards.
CEFs often trade at a substantial discount to NAV, but can also trade at a premium.
Owen A. Lamont and Richard H. Thaler argue that various explanations might plausibly account for "moderate" discounts or premia, but extreme cases appear anomalous and seem to violate the "Law of One Price" principle.

Summary of Individual Views

Person	Position
Matthew Bishop and Michael Green	Full acceptance of the hypothesis goes against the thinking of Adam Smith and John Maynard Keynes, who both believed irrational behavior had a real impact on markets
John Quiggin	Bitcoin is "perhaps the finest example of a pure bubble" and conclusively refutes the EMH; unlike gold or tobacco it has no source of value independent of people's willingness to accept it
Tshilidzi Marwala	The greater the number of AI-based market participants, the more efficient markets become
Warren Buffett	Argued against the EMH in his 1984 "The Superinvestors of Graham-and-Doddsville", yet recommends index funds for most investors
Charlie Munger	The EMH is "obviously roughly correct", but "extreme" commitment to it is "bonkers"
Burton Malkiel	"The preponderance of statistical evidence" supports the EMH, but there are enough "gremlins lurking about" to prevent conclusive proof
Philip Pilkington	The EMH is a tautology masquerading as a theory
Paul Samuelson	The market is "micro efficient" but not "macro efficient"
Andrew Odlyzko	The UK Railway Mania of the 1830s and 1840s demonstrates market inefficiency
Peter Lynch	The EMH contradicts the random walk hypothesis
Joel Tillinghast	The EMH is "more true than not", but not accurate in all cases
Jack Schwager	The EMH is "right for the wrong reasons"

Details Behind Some Views

Warren Buffett and Charlie Munger

Buffett says the preponderance of value investors among the world's money managers with the highest rates of performance rebuts the claim of EMH proponents that luck is the reason some investors appear more successful than others.
Nonetheless, Buffett has recommended index funds that aim to track average market returns for most investors.
Munger says a hypothetical average investor will tend towards average results, and "it's quite hard for anybody to [consistently] beat the market by significant margins".
Munger believes the theory's originators were seduced by an "intellectually consistent theory that allowed them to do pretty mathematics [yet] the fundamentals did not properly tie to reality".

Philip Pilkington: The Tautology Argument

Taken at face value, the theory makes the banal claim that the average investor will not beat the market average, which is a tautology.
Proponents usually say that any actual investor will converge with the average investor given enough time.
When shown that a small minority of investors do beat the market over the long run, proponents say those investors were simply "lucky".
Pilkington argues that this insulates the theory from falsification, so, drawing on Hans Albert, the theory falls back into being a tautology or a pseudoscientific construct.

Paul Samuelson: Micro vs Macro Efficiency

The EMH is much better suited for individual stocks than for the aggregate stock market as a whole.
Research based on regression and scatter diagrams, published in 2005, has strongly supported this dictum.

Andrew Odlyzko: UK Railway Mania

When railroads were a new and innovative technology, there was widespread public interest in trading rail-related stocks.
Large amounts of capital were devoted to building more rail projects than could realistically be used for shipping or passengers.
After the mania collapsed in the 1840s, many railroad stocks were worthless and many planned projects were abandoned.

Peter Lynch: A Contradiction

Lynch was a Fidelity mutual fund manager who consistently more than doubled market averages while managing the Magellan Fund.
Both the EMH and the random walk hypothesis are widely taught in business schools without seeming awareness of a contradiction:
- If asset prices are rational and based on all available data, then fluctuations in asset price are not random.
- If the random walk hypothesis is valid, then asset prices are not rational.

Joel Tillinghast

He accepts a "sloppy" version of the theory allowing for a margin of error.
He contends the EMH is not completely accurate, given the recurrent existence of economic bubbles and the fact that value investors have tended to outperform the broader market over long periods.
He asserts that even staunch proponents admit weaknesses when assets are significantly over- or under-priced, such as double or half their value according to fundamental analysis.

Jack Schwager

He agrees it is "very difficult" to consistently beat average market returns, but says this is not due to information being distributed instantly to all participants.
Information may be distributed instantly, but may not be interpreted or applied in the same way by different people, and skill may play a factor.
Markets are difficult to beat because of the unpredictable and sometimes irrational behavior of humans who buy and sell assets.
He cites several instances of mispricing that he contends are impossible under a strict or strong interpretation of the EMH.

🏦 The 2008 Financial Crisis

The 2008 financial crisis led to renewed scrutiny and criticism of the hypothesis.

Critics

Jeremy Grantham: said the EMH was responsible for the crisis, because belief in it caused financial leaders to have a "chronic underestimation of the dangers of asset bubbles breaking".
Roger Lowenstein: said the Great Recession "could drive a stake through the heart of the academic nostrum known as the efficient-market hypothesis."
Paul Volcker: said that among the causes of the crisis was "an unjustified faith in rational expectations, market efficiencies, and the techniques of modern finance."
Laurence B. Siegel (2009, Financial Analysts Journal): "By 2007-2009, you had to be a fanatic to believe in the literal truth of the EMH."
Martin Wolf: at the International Organization of Securities Commissions annual conference in June 2009, dismissed the hypothesis as a useless way to examine how markets function in reality.
Paul McCulley: said the hypothesis had not failed, but was "seriously flawed" in its neglect of human nature.
Richard Posner: backed away from the hypothesis and accused some Chicago School colleagues of being "asleep at the switch", saying deregulation "went too far by exaggerating the resilience" of laissez-faire capitalism.

Defense by Eugene Fama

Fama said the hypothesis held up well: stock prices typically decline prior to a recession and in a state of recession.
Prices started to decline in advance of when people recognized that it was a recession, "exactly what you would expect if markets are efficient."
Even so, Fama said "poorly informed investors could theoretically lead the market astray" and that prices could become "somewhat irrational" as a result.

⚖️ Efficient Markets in Securities Class Action Litigation

Efficient market theory has been applied in Securities Class Action Litigation.
Together with "fraud-on-the-market theory", it has been used both to justify such cases and as a mechanism for calculating damages.
In the Supreme Court case Halliburton v. Erica P. John Fund (No. 13-317), the use of efficient market theory in supporting securities class action litigation was affirmed.
Justice Roberts wrote that the ruling was consistent with Basic because it allows "direct evidence when such evidence is available" instead of relying exclusively on the efficient markets theory.

Efficient Market Hypothesis: Finance Study Notes