Myths & Breakthroughs

How the Efficient Market Hypothesis Can Lead to Inefficient Investment

The market is impossible to beat. At least, that’s what proponents of the Efficient Market Hypothesis (EMH) would have you believe. Developed by University of Chicago economist and Nobel laureate Eugene Fama in the 1970s, the Efficient Market Theory has become a cornerstone of modern economic thinking and investment strategy.

It’s core assumptions are widely preached and strongly influence the behavior of stock market investors. However, a few simple rebuttals can flip these assumptions, turning efficiency to inefficiency. Here’s a breakdown of the efficient market hypothesis, its impact, and its oversights.

Principles of the Efficient Market Hypothesis

  1. The market is so efficient that stock prices reflect all of the relevant information that is available at the time. Therefore …
  2. It is impossible either to buy undervalued or to sell overvalued stocks, because stocks always trade at their fair value. Meaning …
  3. It is impossible to beat the market through market timing or stock selection, because all stocks are fairly priced at all times. Hence …
  4. Investment outcomes are determined by chance, not skill, so the only way to earn higher returns is to purchase riskier investments.

The theory has both supporters and detractors who shape their investment strategy according to their faith in the efficiency of the market, Even though a growing number of people are admitting and attesting to the theory’s flaws, and therefore invalidating significant parts of it. For supporters, the theory lays the groundwork for a fairly straightforward investment strategy: buy, hold, diversify, which is simplistic and not enough, alone, to ensure success. Here’s how the logic goes:

Investment Strategy for Efficient Market Supporters

  1. Investors employ a buy-and-hold strategy, believing that, as they can’t beat the market, their best bet is to ride the (predictable) historically slow upward trend of the market over time, because that trend will inevitably continue in the United States, (this is akin to past performance guaranteeing future performance which almost every disclaimer in the investment world preaches against investors falling victim to.
  2. Investors diversify their holdings, favoring groups of stocks over hand-picked stocks, believing (incorrectly) that packaged products offer better market representation (and that it’s impossible to hand-pick high performing stocks).
  3. Investors use an (arbitrary) stock style box approach to buy investments in every category—a growth company vehicle, a value company vehicle, a blended , large, mid and small cap instruments,—believing this to be the best way to build a widely diversified portfolio which has investments that zig when others zag. We found this did not work well in 2007-2009 when almost all stock assets declined simultaneously.

The problem with the Efficient Market Hypothesis is that it completely ignores the success of investors (the Warren Buffetts of the world) who have repeatedly been able to buy low and sell high or regularly find companies that outperform the market consistently. The theory also overlooks a number of other key points.

Oversights of the Efficient Market Hypothesis

  1. Economic theories assume that all markets are equal and that all markets function perfectly. In reality, investment markets are imperfect Therefore …
  2. The Efficient Market Hypothesis’ “fair price,” as determined by a perfect market, is theoretical only. Since real markets are imperfect, a stock’s fair price (based on an investor’s assessment of a company’s financial information) can differ from the stock’s market price. And …
  3. By identifying differences between the fair value and the current market value, investors sometimes can and do beat the market. Instances of this were neither acknowledged nor directly studied during Fama’s original research, an oversight that undermines the theory’s conclusions. Besides …
  4. Even if markets do not assign unfair values, humans do. Driven by their understandings as well as emotions, investors may panic and sell when they fear losses, or just sell knowing they are better off missing a large decline and re-entering later, causing stock values to drop below their fair value. Investors can also exaggerate the value of assets, and their speculations can create a market bubble that drives prices beyond their fair value.
  5. How can a company generating the same amount of revenue and earnings one day be worth 100 and a few months later be worth 50? That is not efficient or rational.

    Accepting these points, it stands to reason that an investment strategy based on the Efficient Market Hypothesis may be ill advised. Holding onto stocks during extreme market downturns lessens an investor’s potential returns and increases his or her potential losses when a more tactical strategy of buy low sell high may work better.

    For more on the inefficiencies of the Efficient Market Hypothesis, read Min Deng’s article “Death of Efficient Market Hypothesis.

    As Mr. Deng put it, (we paraphrase) If we can agree the goal of investing is to find untapped market opportunities, and we do not realize the flaws of the EMH (Efficient Market Theory/Hypothesis), then we might become the untapped market opportunity.

    In other words if we sell at the bottom of a crash someone who sold higher and has cash will pick up our stock from us on the cheap. There is a buyer and a seller for every trade, always a winner and a loser. By definition inefficient. Efficiency would mean all investments stay the same price and move up proportionally over time for every company. That doesn’t happen.

    The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results.

    Article tracking number 1-499346

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