The Consequences Of Believing In Efficient Market Hypothesis

Last update on Sept. 19, 2013.

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In the last installment of this series, we discussed what 'Efficient Market Hypothesis' (EMH) is, and why we should care. Believing or disbelieving in EMH will make you invest very differently, much like how your religion (or lack of it) will lead you down very different paths for your life.

In this installment, we will examine the evidence for EMH, and the implications for believing in EMH.

Adademic Literature

Academics started to become interested in an important question as far back as the 40's. 'Can investment professionals beat the market'? In other words, can they get a higher return on their investments than the market as a whole? They released a string of papers examining the performance of investment professionals, and they came up with: 'No'. Over the long run, most investment professionals couldn't beat the market meaningfully. These results still hold today.

The academics then started studying the movement of stock prices. They wanted to know if there was some pattern to these movements. But after applying statistical techniques, they concluded that stock prices followed a purely random motion. If this really was true, it spelled trouble for traders who relied on past movements in stock prices to predict the future. The research was saying that such traders were doing nothing but gambling, as the outcome of their trades were totally random.

But why did the markets behave randomly? Why couldn't investment professionals consistently beat the market? To answer these questions, the academics coined the term 'Efficient Market Hypothesis', and then they defined it.

'A market in which prices always "fully reflect" available information is called "efficient"' - Eugene Fama, 1970

Fama basically says that all available information on every stock out there has been thoroughly digested by rational investors, so the stock price is 'perfect' - i.e. no stock is ever overvalued or undervalued. This marks the zenith of EMH in academic literature. Just a couple of years after Fama made this statement, Burton Malkiel published a best selling book called 'A Random Walk Down Wall Street'

Ever since then, EMH came under attack in the academic world. Many, many papers cited both the evidence against EMH and its theoretical foundations. Some of the evidence even came from Fama himself. We will see some such evidence in the next few installments. Nevertheless, the academic world on the whole still believes in EMH today, although that might be changing.

Why do academics still cling to EMH in the face of many discrepancies? I have my own personal theories. I think academics like to imagine that people are rational beings. Because academics themselves are rational people, why should they expect anything else from the public? But also, I think it's far more convenient for academics to assume that markets are efficient. Having efficient markets allow them to describe the world using simple, beautiful equations - the kind you see in physics. If you introduce inefficient markets run by irrational people, their equations get far messier.

Implications Of Believing In EMH

If you believe in EMH, it means that neither you, nor me, nor Warren Buffett, nor anybody else on the planet can consistently outperform the market. Sure, some will get lucky from time to time. If you flip a million coins, one of them will turn up heads 20 times in a row. But that same coin won't have any greater shot of turning heads the next flip.

For EMH believers, there are only two things you can do to improve investment performance. 1. Diversify, 2. Cut costs. Diversifying won't get you any higher returns, but it will reduce your portfolio's risk. As for cutting costs, since no one can beat the market, you shouldn't pay someone to do a better job with your money. You should therefore just find the lowest cost way to manage your portfolio.

This is why blogs like the Canadian Couch Potato are obsessed with minutiae regarding costs. Some of the advice he gives will save you literally no more than around 0.05%/year. If you have a $10,000 portfolio, following his advice will save you $5/year. The same goes for other investment professionals who believe in EMH. They will find you ways to save on taxes and other costs. But they will never change their portfolio with the belief that doing so will get their clients higher returns.

Now, I believe that diversifying and cutting costs are good. That's why I still somewhat endorse the Canadian Couch Potato, and will recommend other financial advisors who believe in EMH. I believe that with their methods, you will outperform most mutual funds.

However, 'good' can be the enemy of 'great'. Investing like an EMH believer will get you 'good' results, but I think you can do much better.

As an EMH non-believer, I spend far more time trying to pick winning investments, and far less time worrying about costs. So far, I've been successful with my own money, and God willing, I will continue to be. While EMH believers have been spending time saving 0.1% here, and 0.1% there, I've earned many percentages more above the market every year. If you become a member of MoneyGeek, you will benefit from my efforts to generate the highest risk-adjusted returns as well.

In the next installment, I will begin to show you some fun case studies that disprove the EMH.

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