Efficient Market Hypothesis: Is The Stock Market Efficient?

An important debate among stock market investors is whether the market

is efficient — that is, whether it reflects all the information made

available to market participants at any given time. The efficient

market hypothesis (EMH) maintains that all stocks are perfectly

priced according to their inherent investment properties, the

knowledge of which all market participants possess equally. At first

glance, it may be easy to see a number of deficiencies in the

efficient market theory, created in the 1970s by Eugene Fama. At the

same time, however, it’s important to explore its relevancy in the

modern investing environment.

*Tutorial:* Behavioral Finance

Financial theories are subjective. In other words, there are no proven

laws in finance, but rather ideas that try to explain how the market

works. Here we’ll take a look at where the efficient market theory has

fallen short in terms of explaining the stock market’s behavior.

EMH Tenets and Problems with EMH

First, the efficient market hypothesis assumes that all investors

perceive all available information in precisely the same manner. The

numerous methods for analyzing and valuing stocks pose some problems

for the validity of the EMH. If one investor looks for undervalued

market opportunities while another investor evaluates a stock on the

basis of its growth potential, these two investors will already have

arrived at a different assessment of the stock’s fair market value.

Therefore, one argument against the EMH points out that, since

investors value stocks differently, it is impossible to ascertain what

a stock should be worth under an efficient market.

Secondly, under the efficient market hypothesis, no single investor is

ever able to attain greater profitability than another with the same

amount of invested funds: their equal possession of information means

they can only achieve identical returns. But consider the wide range

of investment returns attained by the entire universe of investors,

investment funds and so forth. If no investor had any clear advantage

over another, would there be a range of yearly returns in the mutual

fund industry from significant losses to 50% profits, or more?

According to the EMH, if one investor is profitable, it means the

entire universe of investors is profitable. In reality, this is not

necessarily the case.

Thirdly (and closely related to the second point), under the efficient

market hypothesis, no investor should ever be able to beat the market,

or the average annual returns that all investors and funds are able to

achieve using their best efforts.

This would naturally imply, as many market experts often maintain,

that the absolute best investment strategy is simply to place all of

one’s investment funds into an index fund, which would increase or

decrease according to the overall level of corporate profitability or

losses. There are, however, many examples of investors who have

consistently beat the market — you need look no further than Warren

Buffett to find an example of someone who’s managed to beat the

averages year after year.

*Qualifying the EMH*

Eugene Fama never imagined that his efficient market would be 100%

efficient all the time. Of course, it’s impossible for the market to

attain full efficiency all the time, as it takes time for stock prices

to respond to new information released into the investment community.

The efficient hypothesis, however, does not give a strict definition

of how much time prices need to revert to fair value. Moreover, under

an efficient market, random events are entirely acceptable but will

always be ironed out as prices revert to the norm.

It is important to ask, however, whether EMH undermines itself in its

allowance for random occurrences or environmental eventualities. There

is no doubt that such eventualities must be considered under market

efficiency but, by definition, true efficiency accounts for those

factors immediately. In other words, prices should respond nearly

instantaneously with the release of new information that can be

expected to affect a stock’s investment characteristics. So, if the

EMH allows for inefficiencies, it may have to admit that absolute

market efficiency is impossible.

*Increasing Market Efficiency?*

Although it is relatively easy to pour cold water on the efficient

market hypothesis, its relevance may actually be growing. With the

rise of computerized systems to analyze stock investments, trades and

corporations, investments are becoming increasingly automated on the

basis of strict mathematical or fundamental analytical methods. Given

the right power and speed, some computers can immediately process any

and all available information, and even translate such analysis into

an immediate trade execution.

Despite the increasing use of computers, however, most decision-making

is still done by human beings and is therefore subject to human error.

Even at an institutional level, the use of analytical machines is

anything but universal. While the success of stock market investing is

based mostly on the skill of individual or institutional investors,

people will continually search for the surefire method of achieving

greater returns than the market averages.

*Conclusion*

It’s safe to say the market is not going to achieve perfect efficiency

anytime soon. For greater efficiency to occur, the following criteria