Efficient Market Hypothesis
Let me begin by saying that this is just a hypothesis. There are people who believe in it and there are those who disagree with it. Then, there are those who believe in some version of it. The premise of the Efficient Market Hypothesis or EMH is that in an efficient market, current prices of securities fully reflect all available information. When new information becomes available, prices rapidly adjust to reflect that new information. Where you stand on the EMH drives what you should invest in.
Let’s look at a hypothetical example. Let’s assume that a share of Apple is trading at $100. If news about sales of iPhones doubling comes out, the anticipation that the sales will cause profits to increase and hence drive up the stock price causes investors to buy Apple stock. When there are more buyers than sellers in the market, price goes up. Simple demand-supply economics! Because of the increased demand for the stock, the price keeps rising until investors think that the price fully incorporates the information about the doubling of sales. Investors are also continuously looking for information that will help them profit. So any news that drives prices is consumed immediately. With the rise in algorithmic trading, and increased computer power being used for making investment decisions, the rise in price is almost instantaneous.
If the price did not readjust immediately, an investor would have time to buy Apple shares and make a huge profit until the rise in the stock price. You may have noticed that this is never the case. You may have never been able to profit from newly released information. This almost instantaneous adjustment of prices to new information is a characteristic of efficient markets.
Eugene Fama, a Nobel laureate in Economics at the University of Chicago, formalized this theory of efficient market hypothesis or EMH. The basic premise behind the EMH is that there is intense competition among investors to find and exploit any advantages in the market. This competition drives away inefficiencies quickly making the market efficient. In short, all currently available information gets priced into the security immediately making it difficult, if not impossible, to profit from it.
But what kind of information are we talking about? Academicians and investors agree that prices will fully reflect all current information but disagree on the type of information that gets incorporated into prices. This has led to three versions of the EMH.
Weak-form Efficient Market Hypothesis
This version assumes that efficient market hypothesis is correct with respect to past asset prices, returns, trading volume data, etc. What that means is by analyzing historical data about the asset, no investor should be able to make any profits. However, one can profit from any other information with this form of EMH.
This version states that asset prices adjust rapidly to any publicly released information. Publicly released information could include security specific public information – such as earnings calls, dividend announcements, etc. and also non-company specific public information – such as political news, economic news – announcements of trade wars, tariffs, etc. Hence, any publicly known information at a given time should be completely incorporated into the prices of all securities.
Finally, the strong form version states that asset prices reflect all public and private information. No single investor or group of investors should be able to profit from publicly released or private information. Private information is something that is not shared and is only known to a few individuals. It includes inside information. Countries with strong laws prohibit investors from acting on private information or engaging in insider trading. There is a hefty fine and jail time for this offense. Hence this version states that there is no way to profit from any information – public or private.
So why did I discuss EMH? When I say that prices incorporate all available information, that information also includes any expectations of future returns. If you expect a company to double its profitability tomorrow, other investors studying that company may also have similar expectations. Those expectations are also part of the information and will be priced into the security today. Today’s prices. incorporate any expectations for the future. So any changes in future prices are unpredictable.
So if EMH is correct, there is no way for me to predict future prices and no way for me to beat the market. How can I then choose how to invest if there is no way to predict prices? This is what makes EMH so controversial.
Investment managers deny EMH because their livelihoods depend on it. Don’t take anybody’s word on it, look for hard evidence. If you look at data, you will find only a few money managers that have been able to generate above-market returns and do it consistently. Of course, these managers are expensive. Net of manager fees, your portfolio would most likely be in line with the market or even underperform the market. Most money managers out there are mediocre. They may have a year or two in which they were able to beat the market but more often than not, they lag market returns. So what do you do and how do you invest?
If you can’t beat them join them – If you can’t beat the market, buy the entire market or a slice of it. You may not hold all winners but you will also not hold all the losers. Of course, this is only one strategy to apply to your portfolio. The easiest and most cost-effective way to do this is through ETFs. Be sure to check the expense ratio before investing.
Anomalies of the Efficient Market Hypothsis
There are some anomalies, however. And in those cases, EMH has not been true. For example, many investors will sell stocks in late December for various tax reasons. They reacquire these stocks and others in January to take advantage of the low prices. The prices eventually rise within the first week or first trading day of the year causing the January effect.
There is also a Stock Split effect. Data indicates that stock splits will usually lead to an increased demand for shares cause stock prices to rise because of lower prices. EMH would not be able to explain those price increases.
Broad market or single securities
Having said that, the Efficient Market Hypothesis is just a hypothesis. There is no way to tell whether EMH is true or false. It becomes a matter of belief. If you think EMH is true, then investing in broad market through mutual funds or broad market ETFs the right strategy for you. You may believe that EMH is not true all the time; then investing in specific stocks or assets may be the way for you. If you want to be an active investor who wants to beat the market, you will have to put in the time and effort to study and understand companies and choose the ones that you believe will help you beat the market.
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