Efficient Market Hypothesis

For some share enthusiasts, the EMH is not a nice thought. The theory argues that careful share selection based on myriad factors, including analysing company financials, reading news and analyst opinions or charting historical share prices is pointless. The concept of analysing whether a company is under-or over-valued relative to its current market price is also a waste of time. And its advice to traders who buy and sell shares according to the prevailing trend – don’t bother.

Understandably, the efficient market hypothesis (EMH) has attracted a flood of criticism since Professor Eugene Fama in the late-1960s unleashed it on the investment world. Still, over forty-years later, the theory continues to impact markets, products and investor behaviour, particularly in the United States. 

So what is the EMH? In short, the EMH states that markets are largely efficient. And in being efficient, a share price will hover around its true value most of the time. If it does spike or plunge down the charts on occasion, the EMH advocate will tell you that this price activity is random, and therefore impossible to predict or exploit for profit.

The EMH states that share prices constantly reflect all available information including the manner in which investors interpret that information. It is based on the premise that no single investor has access to information that others don’t – and as such, cannot consistently profit at another’s expense. So, if buying and selling shares for profit is a waste of time, what does the EMH tell us to do instead? In essence, their advice is to do very little.

The biggest gripe of advocates of the EMH is the popularity of the active fund manager. While the EMH tells us that markets are largely efficient, active fund managers aim to exploit inefficiencies in the market to achieve superior returns. Investors keen to ‘beat the market’ therefore pay active managers a premium for their stock-picking abilities, in addition to the extra brokerage incurred from active management.

Supporters of the EMH argue that the only people who achieve superior returns from active management are the managers themselves. They point to empirical evidence showing that the majority of active managers under-perform the market, particularly over the long term. They say that if leading fund managers can’t consistently manage to beat the market, then the average investor has little hope of pulling off a better result. And if you can’t beat the market, then the only option left is to join it – by investing in an index or exchange traded fund (ETF) that tracks or mirrors the performance of the market. The EMH states that investors should spend more time analysing such things as their portfolio’s asset allocation based on their risk profile and tax bracket – and spend less time pulling up stock quotes, obsessing over charts, data and financial news.

This is all well and good, but what happens when a political or economic event causes the market to stumble? If a market dives by 20 per cent in one day – is it still efficient?

Critics of the EMH highlight examples when the market is not always efficient and when glaring opportunities can and do present themselves for the astute investor. They point to fund managers who have consistently beaten the market over long periods of time, traders who have retired to the Caribbean with millions milked from years of successful bets, and hedge fund managers who pull in more than a billion dollars in annual trading revenue. How does the EMH stand up to the existence of those who clearly see opportunities in the market that others don’t?

The EMH refers to market corrections as anomalies: these short-lived events are so random that no investment strategy can predict them with any accuracy. Supporters also contend that the transaction costs incurred in chasing new investment opportunities will often outweigh the gains made. So did the hedge fund manager pull in a billion dollars in trading revenue from sheer luck alone?

Economics is never black and white and so it is with one of the most famous investment theories of our time, the EMH.

The biggest paradox of the EMH is that if we all believed in it, it would disappear in a puff of smoke. Why? Well, put it this way; if we all bought index funds and ignored the latest sharemarket news and data, then over time stocks would stgiate further from their true value. In essence, the market would become more inefficient leading to a plethora of speculative opportunities for the smart investor.