The Efficient Market Hypothesis (EMH), brought to the world’s attention by Eugene Fama in 1970, is one of the most influential and discussed financial theories out there. Whether you’re an investor, a student of finance, or just someone trying to justify why your ‘foolproof’ stock picks didn’t work out, understanding EMH is essential.
In this week’s edition of Bullish Beginnings, we’ll unpack the arguments for and against EMH to give you a complete perspective on how efficient markets really are, and whether or not you should finally give up on beating the SPY.
Efficient Markets: The Basics
At its core, the Efficient Market Hypothesis suggests that stock prices fully reflect all publicly available information. This means that only new, unexpected information moves prices. So, if you think you’ve found a hidden gem stock that will outperform, the market has probably already priced it in.
Fama defines three levels of market efficiency. The weak form states that all past trading data is already reflected in stock prices, making technical analysis useless. So, all those Instagram traders with rented Lamborghinis trying to convince you to buy their scam courses? Yeah, they’re out of luck. The semi-strong form goes a step further, arguing that stock prices instantly adjust to all publicly available information, meaning fundamental analysis won’t give you an edge either. If true, this means that Benjamin Graham’s approach to value investing wouldn’t be able to consistently outperform. The strong form takes efficiency to the extreme, claiming that stock prices reflect all information—public and private. If this were true, even corporate insiders wouldn’t have an edge (although, insider trading scandals suggest otherwise).
This all sounds airtight in theory, but in reality, there are plenty of cases where markets don’t seem to behave so efficiently. Warren Buffett, for example, has been beating the market for decades using fundamental investing principles. And let’s not forget about insider trading cases where people have used non-public information to make massive profits, albeit illegally.
Can We Even Test for Market Efficiency?
Here’s where things get tricky. The Joint Hypothesis Problem makes it incredibly difficult to test whether markets are truly efficient. To do so, we would need a perfect asset pricing model to compare expected returns against actual returns. But if our model is flawed, how do we know if it’s the market that’s inefficient or if it’s just our model that’s wrong?
It’s like trying to prove you’re a great chef using a terrible recipe. If the dish turns out awful, is it because you’re bad at cooking, or is the recipe to blame? In finance, this means we’ll likely never have a definitive answer. All we know is that market efficiency is hard to prove, and just as hard to disprove.
The Case for Market Efficiency
Despite the sceptics, EMH has plenty of evidence backing it up. Studies consistently show that markets digest and reflect new information with incredible speed. By the time you read a stock tip, hedge funds and algorithms have already traded on it. The idea that anomalies can persist indefinitely is also questionable. The moment investors catch on to a predictable pattern, they exploit it, which in turn eliminates the pattern altogether. A great example is the January effect, where stocks supposedly rise at the start of the year. Once investors caught on, the effect weakened significantly.
Passive investing is another strong argument for market efficiency. The vast majority of active fund managers fail to beat the market over the long run, which suggests that trying to outsmart the market is a losing game. If inefficiencies were common, more active managers would consistently generate excess returns. The Fama-French three-factor model also provides further support, showing that stock returns can largely be explained by market risk, size, and value factors rather than individual stock-picking skill.
The takeaway here is that markets, for the most part, seem to be efficient enough to make outperformance incredibly difficult. While short-term mispricings may occur, they are quickly arbitraged away, making it tough for investors to capitalise on them consistently.
The Case Against EMH
Not everyone is convinced by EMH, and for good reason. There are clear cases where markets do not behave efficiently. A number of well documented anomalies challenge the idea that stock prices always reflect fair value. The size effect, where small-cap stocks tend to outperform large-cap stocks, contradicts market efficiency. Similarly, the value effect, which shows that stocks with high book-to-market ratios tend to generate higher returns, shouldn’t exist if markets were truly efficient. Perhaps the biggest slap in the face to EMH is the momentum effect, which demonstrates that stocks that have been performing well tend to keep performing well in the short term. If markets were efficient, past performance should have no bearing on future returns.
Then, there’s behavioural finance. Investors are far from rational. Herd behaviour, overconfidence, and emotions often override logic. Take the Dot-Com Bubble, the 2008 Financial Crisis, or even the GameStop events. If markets were perfectly efficient, these kinds of speculative mishaps wouldn’t happen. Critics argue that blind faith in EMH contributed to the reckless risk taking that led to the 2008 crash. If regulators and investors believed markets could efficiently price everything, they wouldn’t have underestimated the dangers of subprime mortgages.
And then, of course, there’s Warren Buffett. If EMH were entirely accurate, how has he managed to beat the market for decades?
The Great Divide: Can We Have It Both Ways?
In 2013, the Nobel Prize in Economic Sciences was split between Eugene Fama, the father of EMH, and Robert Shiller, a critic of market efficiency. This divide highlights the ongoing debate in finance: do markets efficiently reflect information, or are they driven by irrational investor behavior?
The reality is that both sides have a point. Markets are mostly efficient, but inefficiencies do exist. AQR’s opinion in *The Great Divide *says, markets operate in a hybrid state where most prices are rational, but some inefficiencies persist due to investor psychology. Anomalies like value and momentum can exist for a while, but once investors exploit them, they tend to fade away.
So, what does this mean for investors? If you believe in EMH, passive investing is your best bet. The market prices stocks fairly, so your best strategy is to buy and hold. If you think markets are inefficient, then actively investing by identifying mispricing’s, using momentum strategies, or following value investing principles could work. This is why it is recommended that you, as a rational investor, should not take sides, and instead recognise when markets are effective and when they are not and capitalise accordingly.
Final Thoughts
So, markets are efficient most of the time, but not always. Financial crises, bubbles, and anomalies suggest that inefficiencies exist, but they don’t go on forever. EMH remains a solid foundation for finance, but behavioural finance provides an essential counterbalance.
So, is EMH fact or fiction? The answer is somewhere in the middle. Whether you choose to embrace market efficiency or try to outsmart it is up to you.
