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January 09 2011| Filed Under Financial Theory, Stock Analysis, Stocks,
Trading Psychology
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. (For background reading, see What Is Market Efficiency?)
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. (For more reading on beating the market, see the frequently asked
question What does it mean when people say they "beat the market"? How do they
know they've done so?) 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. (To learn more about Warren
Buffett and his style of investing, see Warren Buffett: How He Does It and The
Greatest Investors.)
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 must be met: (1)
universal access to high-speed and advanced systems of pricing analysis, (2) a
universally accepted analysis system of pricing stocks, (3) an absolute absence
of human emotion in investment decision-making, (4) the willingness of all
investors to accept that their returns or losses will be exactly identical to
all other market participants. It is hard to imagine even one of these criteria
of market efficiency ever being met.