Simplifying the Efficient Market Hypothesis

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Most backers of the efficient market hypothesis firmly believe that the financial markets will not allow you to earn high returns unless you accept a fair amount of risk.

In a well-known story often told to explain the concept, a finance professor and a student are walking to class when they come across a $100 bill lying on the ground. As the student stops to pick it up, the professor says, "Don't bother. If it were really a $100 bill, it wouldn't be there."

In other words, people who agree with the theory don't think that free cash is just lying around for the taking, whether for the highly savvy trader or for a brand-new trader.

What Does the Efficient Market Hypothesis Claim?

The efficient market hypothesis says that as new information arises, the market absorbs the news almost in real time, and the prices of stocks and other securities adjust along with it. Those who agree with the thesis say that the market is so adept at incorporating all known data that no amount of analysis can provide an edge over all the millions of other people who also have access to all of the same information.

Those who support of the efficient market hypothesis state that no matter how shifty a stock price may behave, the market simply does not create chances that allow traders to earn massive returns without taking on risk.

How Does It Affect the Market?

After the efficient market hypothesis became common knowledge, it could be seen at work in the market. For instance, index funds were bought and sold at a much higher rate. This effect should not be a surprise. After all, if expert traders or brokers have no true edge over others and do not "beat the market," then why would you pay a higher fee to them with the hope of doing better?

In an attempt to avoid the stock churn outlook, some decide that it is better to "own the market" through the index fund.

Many modern advisors and finance experts propose a method called Modern Portfolio Theory, which in practice looks very much and very simply like buying index funds.

If you invest using this method, you'll pay much lower fees, and as a result your holdings will compound at a greater rate. That, in turn, makes for a larger potential investment value over time.

Why People Try to Beat the Market

As of March 2020, 41% of exchange traded funds (ETFs) and mutual fund assets under management in the U. S. were passive funds, up from just 3% in 1995. Use of passive funds is clearly on the rise, and according to Bloomberg the amount of money held in passive assets is on track to exceed that of active funds by 2026 or sooner.

Despite the rise in passive investing, a quick look through the many funds on the market shows that there are still plenty of products trying to prove the efficient market hypothesis wrong.

People who oppose the theory ask, "Why did the market remain so mispriced for so many years after the recent recession? Sure, in the short-run it may have been mispriced, but for that many years?" 

As stated in a 2017 article in The Economist, one idea is that the market is "efficiently inefficient." The average investor won't be able to beat the market, but if a massive bank throws enough money and tech power into the effort, it will find success. That may be why computerized trading came to dominate the market in the early 2000s, when the number of trades made by computers began to exceed those made by human actors.

How Does Risk Factor In?

Those who agree with efficient market hypothesis would say that the examples above are simply payment for risk. The real estate tycoon who purchased a home or real estate at the low of the 2009 recession, for example, made a handsome profit because of the risk they took on.

Consider the gains seen by a day trader. A player who makes trades with such high frequency has no way to predict whether a stock price will be up or down in a matter of minutes or hours, so their level of risk is high. If they make money, it's thought to be payment for an increased risk.

Markets Are Not Rational

Note that the efficient market hypothesis does not mean that markets are rational or that they always price assets with perfect accuracy. In the short run, investments can become over-valued (think tech stocks during the dot com bubble, or real estate during the housing bubble) or under-valued (think stock prices in March 2009). The value or assessed value of such assets on the market has a lot to do with investors' confidence and how willing they are to accept risk.

Over longer spans of time, investment prices will reflect the expected earnings growth of their underlying assets. The efficient market hypothesis has been the subject of debate among scholars in the field since its debut in the 1960s.

All data points to the fact that investing for the long term is a more sound method than trying to cash in quickly. That alone might mean that there's more to efficient market hypothesis than the critics want to let on.

Article Sources

  1. Burton G. Malkiel. "The Efficient Market Hypothesis and Its Critics," Pages 59-60. Journal of Economic Perspectives.

  2. Morningstar. "A Brief History of Indexing."

  3. Federal Reserve Bank of Boston. "The Shift From Active to Passive Investing: Potential Risks to Financial Stability?" Pages 1-2.

  4. Bloomberg Intelligence. "Passive Likely Overtakes Active by 2026, Earlier if Bear Market."

  5. The Economist. "Is Efficient-Market Theory Becoming More Efficient?"

  6. Deutche Bank Research. "High-Frequency Trading: Reaching the Limits," Page 2.

  7. FRED Economic Data. "Median Sales Price of Houses Sold for the United States."

  8. Federal Reserve Bank of Atlanta. "Stock Prices in the Financial Crisis."

  9. UCL Department of Computer Science. "History of the Efficient Market Hypothesis," Pages 3-7.