by Darwin on January 24, 2011

Efficient Market Hypothesis will be this weeks MBA Monday topic (check out that category for everything from Present Value of Money to Tax Shields).  The premise of the Efficient Market is relatively straightforward, but like many economic theories, there are varying levels of degree you can take it too, complex studies and results abound, and at the end of the day, people are generally mixed on whether they believe or adhere to the fundamentals.

What is the Efficient Market Hypothesis?

The premise of the Efficient Market Hypothesis is that markets and participants are at all times on a level playing field with respect to information.  As such, no one person, trader, investor, speculator, whateverhas an edge over anyone else and thus, nobody should ever be able to beat the market over an extended period of time for any reason other than shear luck.

The implications of this theory are rather drastic.  For one, it would posit that you should never buy or trade stocks individually since you have reason to believe your investment strategy should outperform a monkey throwing darts at a stock section of a newspaper.  Next, theres no such thing as value investing.  If you think a stock a trading at a discount to its intrinsic value, youre wrong the market is already pricing in the stocks current valuation.

Digging Deeper into Efficient Market Hypothesis

Taking the research a bit further, there are different types of scenarios which manifest themselves:

• Weak -Weak is primarily aligned with what I described above, where all information on stocks, bonds, commodities and other asset classes are already factoring in all PAST publicly available information.

• Semi-Strong -This scenario believes further, that this public information pricing is immediately instantaneous.  This notion is further bolstered by the advent of the internet and instantaneous information.  Basically, as soon as any material information is disseminated, it is immediately digested by the masses and instantaneously reflect in the share price of publicly traded companies.

• Strong -Strong stretches the theory to the brink, saying not only are the above true, but even insider information that most of the trading public is NOT privy to is already reflected in market pricing.

Efficient Market Theory Examples and Contradictions

Some common examples demonstrating the validity of efficient market theory might be the commonly known phenomena that even most professional money managers cannot beat the returns of their benchmark index over long periods of time.  This tends to demonstrate that if these seasoned professionals who derive a living solely from understanding and investing in the market cant beat an index, nobody can because every time they buy or sell a stock, the proper price was already reflected.

A common contradiction to the theory is the bubble and collapse phenomena weve grown to know all too well.  How could housing have run up double digits for years, then collapsed precipitously in an unprecedented fashion?  How could some of the worlds largest, most profitable, and top-performing equities have collapsed into bankruptcy, takeovers and government assistance virtually overnight?  Surely, when individual equities are bouncing 20-30% overnight, information was not accurately factored into the share price the day before, right?  Some would explain this as market-panic, herding, and other anomalous behavior that overrides known information or conventional market behavior.  Others would simply point to this as a contradiction of the theory.

Additionally, some investors (these days, often hedge fund managers) have been shown to consistently beat the market.  They do, however, often employ exotic investment strategies, have access to private companies (see how to invest in Facebook, Twitter and Groupon ) and other instruments not available to the general public.  But there are some known value investors and special situation investors, arbitrageurs and other specialists that actually DO beat the market.  So, perhaps if the semi-strong hypothesis is in play and theyre getting insider information, perhaps that explains it.  Otherwise, they ARE actually beating the market based on THEIR assessment of market valuations.

As individual investors, we often tend to think were smarter than the next guy.  This is confirmation bias.  Admittedly, I tend to ride high and use my wins and confirmation of my market prowess, while sticking losses somewhere in the back of my mind.  Buying Apple during the financial collapse was genius.  Selling it along the way so I only have 14 shares left now?  Not so genius (Id be worth another $10,000 today if I just held all shares and sold last week).  So, the truth is likely somewhere in between.  I do trade individual stocks, but not as much as I used to.  I rely more on ETFs, actual strategies for special situations and arbitrage (see this gold pairs trade easy money), and stock options (200% gain overnight).  I like to think Im a better stock-picker than the next guy, but frankly, most of my alpha has come from the non-stock trades of the type cited above.

Are you a Believer?