Efficient Markets Fact and Fiction

For almost 50 years, one of the most controversial ideas in finance is that markets are efficient, as presented by Gene Fama’s Efficient Market Hypothesis (EMH) in 1966.

Let’s start with a simple definition of EMH: Current market prices incorporate all available information and expectations and are the best approximation of intrinsic value.

In some ways, it’s such a simple statement that it’s a little surprising that it’s so controversial.  After all, the intrinsic value is un-observable and tens of thousands of investing professionals worldwide are making their best estimates with something that matters: their money.

On the other hand, we all know that markets can get a little crazy, like the tech bubble or the flash crash.

This leads me to fiction number one, that market prices are always right. That’s impossible and there are dozens of examples where that isn’t true – in fact, there’s a whole segment of hedge funds called arbitragers that consistently profit from the inefficiency.

Fiction number two is that prices are always stable.  We know this isn’t true! We don’t even have to look back very far to see this.  Does it really make sense that the S&P 500 was down -37.0 percent in 2008 and up 26.5 percent in 2009?

Fiction number three is that market returns follow a standard ‘bell’ curve.  It is true that we all refer to market volatility as risk, but everyone in the field knows that you have to look at the skew and kurtosis as well (but what client wants to hear about that?).

When Fama wrote his dissertation, half of the paper was about EMH and the other half was about how market returns don’t follow a bell curve.

Although there are many more fictions, I will just add one more today: that professional money managers can’t beat the market.  It’s actual math that all investors can’t beat the market: for someone to outperform, someone else has to under-perform (there is some new research on this, actually, but I haven’t digested it just yet).

In fact, Fama is one of the consultants at Dimensional Fund Advisors that has helped them develop market beating returns.  They have actually beaten the market by emphasizing our old friends – small cap and value stocks.

One of the real problems for EMH is the existence of momentum.  In theory, simply knowing a stock’s recent relative performance shouldn’t tell you anything about future returns; but in fact, stocks that have gone up recently tend to continue to go up.  That information should be in the price already, but isn’t.

Like most investors, I know that market prices aren’t perfectly efficient, but I do think it’s useful to think of them as reasonably efficient.  I like to play a parlor game with other pros, asking them on a scale of 0-100 with 100 being perfectly efficient, what’s their number?

I’ve had people say ‘zero,’ which is a funny answer to me.  If that were the case, you could imagine a company that announces that they’ve cured cancer but the stock price doesn’t respond at all – it has an equal chance of falling as it does rising because prices are totally random.  Obviously, we know that isn’t true either.

I happen to be around an 80.  It’s a made up number of course, but it seems reasonable to me in that I think the market is mostly efficient, but not all the way or all the time.