Does the Efficient Markets Hypothesis Work?
Scott Rothbort
05/01/09 - 02:52 PM EDT
Most business-school investment classes throughout the world teach the efficient market hypothesis. Many academics espouse EMH as a dominant and overarching theory governing investments. I thought that I would share this theory with TheStreet.com University readers and provide my own opinions as to its veracity.
The EMH was proposed in the doctoral thesis of famed academic Eugene Fama at the University of Chicago. His thesis was an early attempt at integrating behavioral economics into the field of finance.
The EMH is dividend into three sub-hypotheses or forms:
Weak Form: Security prices reflect all security market information from the past. Furthermore, all past rates of return and historical market data cannot predict future prices. Hence trading patterns or rules cannot be gleaned from historical data.
Semi-Strong Form: Security prices adjust rapidly and unbiased manner in response to the release of all new public information. The semi-strong form encompasses the weak form as all historical information is also already in the public's hands.
Strong Form: Share prices reflect all information from both public and private sources. The strong form encompasses both the weak and semi-strong forms of the EMH. The strong form assumes that all information is free of cost and available to everyone at the same time.
So what are the implications for traders and investors under the various forms of the EMH? Under the weak form, trading models that base their returns on past market behavior and technical analysis will not be able to produce consistent returns in excess of the market returns. Some forms of fundamental analysis can yield excess returns under the weak form.
According to the semi-strong from, an investor cannot generate above risk adjusted returns from new public information after it has been released as the price already reflects such information. Thus, under the semi-strong form neither fundamental nor technical analysis can produce consistent excess returns.
The strong from of the EMH assumes that all information is already reflected in security prices. Hence, no type of investor or trader can earn excess returns.
Where does the EMH fall short? Frankly, it is assumption-driven. The weak form assumes that stocks trade in a random fashion. However, many market observers can document that stocks will trend over a discrete period of time in a nonrandom fashion.
The semi-strong form assumes that public information is received by all market participants at the same time; that all public information is processed by all participants at the same time; all market participants take action on public information at the same time; and, that all market participants interpret the public information in a uniform manner.
The strong form assumes the use and dissemination of both public and non-public information just as I just mentioned for the semi-strong form.
How realistic is the EMH? The weakest argument for the EMH is in favor of the strong form. To put it bluntly, the strong form only exists in academic laboratories and in a fantasy world. It simply cannot exist in reality. We have laws and regulations that would prevent certain information from being distributed publicly or selectively. Furthermore, laws and regulations prevent acting upon nonpublic information.
The semi-strong form assumes that everyone will receive and act upon the information simultaneously. That is too simplistic an assumption and does not happen in the real world.
If anything, the weak form would be fleetingly operative in the existing U.S. marketplace. However, there are many people who will trade and make money based upon prior chart patterns, trends or trading history that one has to even question the validity of the weak form of the EMH.
In a world with Jim Cramer, Warren Buffett, George Soros, SAC Capital, Doug Kass and other successful investors, I believe it is hard to prove the EMH in any form is operative. My advice to investors and traders: Do not let a theory like the efficient markets hypothesis get in the way of making money. If you have a fundamental, technical or even a statistical basis for investing or trading, I would suggest sticking to your model or plan as long as it makes money.
