Does The Efficient Market Hypothesis Make Sense To You?
I am sure that most of us have heard of people saying that the stock market is efficient and some of the same people also mention that unicorns roam the land. That doesn’t sound right, but I don’t know enough about unicorns to dispute it.
What is an efficient market?
An efficient market can be a place where prices adjust rapidly to incorporate new information. In short, current market prices reflect all information of the securities.
This means current market price = value of asset
Hence no one can consistently beat the market without taking excessive risk. We will talk about how risk is seen in the financial world another day, some of you might also say that it does not make sense as well!
When theories of the financial market are explored in the academic world, none is more famous than the Efficient Market Hypothesis (EMH). Widely used by business schools, the Efficient Market Hypothesis (EMH) consisted of three sub-hypotheses:
1) Weak-form EMH
This form assumes that current prices fully reflect all market information. Assuming that current market prices already reflect past returns and other market information, this implies that past information should have no link to future returns.
Chartists and technical analysts would definitely not like the sound of this as it means that pattern-based techniques or anything in the past is useless.
2) Semistrong-form EMH
The semistrong-form indicates that current prices fully reflect all public information. This implies that investors who base their decisions on public information would not have an edge in achieving above average returns.
Something to think about would be the issue of how market can be efficient if there are no incentives for investors to beat the market
3) Strong-form EMH
Finally we arrive at the strong-form. This form takes the cake by assuming that prices fully reflect all information be it from public of private sources.
Given that certain information is deemed private, it seemed paradoxical that this type of information would able to be perfectly reflected within prices. If something is private, how would people know. My mind hurts.
Value In Action
I will end by highlighting what James Montier mentioned in his book Value Investing. James Montier mentioned a snippet of Robert Arnott’s speech given to 200 finance professors. He asked how many of them taught the Efficient Market Hypothesis (EMH). Pretty much everyone’s hand was up. He then asked how many believed in it. Only two hands remained, just 1% of them! It is rather amazing that even after 50 years since the inception of the Efficient Market Hypothesis (EMH), there is still no consensus among economist on the utility of the Efficient Market Hypothesis (EMH) in practice.
How can we be expected to buy into this when even the teachers themselves don’t walk the talk?
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