Efficient Market Hypothesis: Understand It To Be A Better Investor

Jake - Author/Founder

Jake - Author/Founder

Hi. I'm Jake. I believe you can build a wealthy life through frugal living and index investing.

Hi.  I link to books & products that I believe can help you improve financial literacy and build wealth. These are affiliate links, meaning I get a commission if you click the link and buy a product. You won’t find a book that I have not read, or a product that I don’t currently use. 

90% of actively managed US funds underperformed the S&P500 In the last 10 years. 

Professional stock selectors often fail to earn excess returns over the market return.

Clearly, beating the market by picking stocks is very hard. 

The reason is market efficiency. Markets have an amazing ability to rapidly “price in” new information.

Millions of investors buy and sell based on new information, changing prices to reflect new info.  The level of efficiency is determined by the accuracy and speed of price movements in response to new info. 

The efficient market hypothesis (EMH) is a critical concept to understand if you want to make solid investing decisions. It’s also the basis for facets of modern finance, including modern portfolio theory

In this post, I share what I know about the efficient market hypothesis because I believe it will make you a better investor. 

  • What is the efficient market hypothesis?
  • Examples of market efficiency.
  • How active investors (stock pickers) make index investing work (super interesting). 
  • Why efficient markets motivate index investing. 
  • How behavioral finance throws a wrench in efficient markets.

Table of Contents

What Is The Efficient Market Hypothesis

A market is “efficient” when the price of a security (Stock/ETF/bond) reflects all available information.

In an efficient market, stock prices must adapt rapidly when new information becomes available. 

Let’s check out how an efficient market would price a stock. Since a stock represents ownership of a business, the stock price is determined by the earnings power of that business. More specifically, stocks are priced based on future earnings expectations and the risk to those future earnings. 

This pricing mechanism is called the Discounted Cash Flow Valuation. It is a way to price any cashflow-generating assets, not just stocks. For more, check out Where Stock Returns Come From. 

DCF is also why I hold no cryptocurrency ….. I don’t understand how crypto generates cash flow. According to DCF, no cashflow, no value. 

Stock price often changes when a business comes out with earnings reports. Millions of investors buy/sell the stock based on the new earnings info. If the earnings are negative relative to expectations, then they will sell and bid down the stock price. The rapid action of many investors makes markets efficient. 

Market efficiency comes in three flavors, from the theoretical perspective. The strong form, semi-strong, and weak.

I go through each type next, but this part is non-critical and more for interest. 

Strong Efficient Market Hypothesis (Strong EMH)

Strong EMH states that markets are very very efficient. 

To be more specific, strong EMH states that public and private information is reflected in stock prices. Under strong EMH, even monopolistic (insider) info is baked into stock prices. 

That means people working inside businesses would need to be buying and selling based on insider info, and “insider info” is leaking out to the public. 

To be clear, these activities are illegal. 

If markets are strong form efficient, it would be impossible for professionals or individuals to beat the market in the long term, apart from random luck. I talk about the difference between luck and skill in my post on decisions vs outcomes. 

Insider selling is illegal before the info is made public. If these laws work, then markets should not be strong-form efficient. I don’t believe markets are strong form efficient, and I discuss why below. 

Semi-Strong Efficiency

Semi-strong EMH assumes that monopolistic info is not priced in. In this case, everyone is following the rules and businesses are managing their private info properly. 

Under semi-strong EMH, information is rapidly “priced in” to stock prices as soon as the information becomes public. 

You see evidence of weak form efficiency when earning reports come out.  Upon earnings release, stock prices jump/fall in response to earnings that deviate from investor expectations.

This shows that insider info was properly managed and was not leaked to the public. It is evidence against strong form EMH and evidence for semi-strong EMH. 

I believe in semi-strong EMH.  

As a regular investor, it would be impossible to legally beat semi-strong efficient markets based on skill. The only way to beat the market would be if you have insider information that millions of other investors have missed. That’s not legal. 

Weak Efficient Market Hypothesis

Weak form EMH looks at the price history. It states that current prices have zero correlation with past price movements.

This renders technical analysis irrelevant. Technical analysis is the assessment of short-term stock price movements to make a profit. So, all even weak form EMH renders day-trading wasteful of time, money, and energy. 

Although weak EMH states that past pricing has zero effect on future pricing, it gives leeway for market inefficiency based on the forward prospects and fundamental analysis.

Weak EMH says that an investor can find mispriced stocks based on discounted cash flow (DCF) analysis of a business.

Weak form EMH is discussed in one of my top 3 favorite investing books: A Random Walk Down Wall Street by Burton G. Milkier.

DCF analysis is called fundamental analysis, and it’s what professional stock pickers do. I learned the most about fundamental analysis in the book The Intelligent Investor by Benjamin Graham and One Up On Wall Street by Peter Lynch. 

Based on pricing, I don’t believe markets are weak form efficient. Instead, they are somewhere between weak-form and semi-strong. 

Efficient Market Hypothesis Examples: How We Know Markets Are Efficient

Okay. The theory is great and all. But how do we know if markets are actually efficient?

Let’s look at three specific examples of market efficiency. 

Example Uno: Active Fund Performance

Actively managed funds are those with a professional investor who selects individual stocks. Individual investors participate in the returns of active funds with mutual funds or ETFs in hopes of beating the market. 

Not only do these fund managers have to beat the market, but they have to beat the market by an amount greater than the fund fees. Otherwise, the individual investor would not see a benefit. 

After fees, active funds as a group fail to beat their benchmark index. A quick look at SPIVA shows that 89% of US mutual funds underperformed the S&P500 in the last 10 years. 

But what about the 10% who are beating the market? Are they exploiting market inefficiency based on skill, or is it luck? 

A look at fund persistence can answer this question. Fund performance would persist if high returns are based on skilled exploitation of market mispricing. 

But this does not happen. Fund performance does not persist. 

The SPIVA Persistence Scorecard looks at persistence. The top 20% of active funds in one year have a 3.5% chance of persisting over the next four years. 

Selecting the top-performing funds provides slightly better results than picking funds at random, indicating that skill is out there and market exploitation is possible, just very hard. 

From my perspective, it makes sense to view the performance of actively managed funds as random luck. By picking a fund, you have a 10% chance of outperforming the market, after fees, over the next 10 years. 

Example Duo: Dual Listed Stocks

Some businesses are listed on more than one stock exchange. These are called “dual-listed” stocks. 

For example, Suncor Energy (SU) is listed on the New York Stock Exchange (NYSE) and the Toronto Stock Exchange (TSE). 

The price of both stocks is set independently by investors on each exchange. In an efficient market, the stock price would be priced the same on both exchanges. Same company. Same price.  

Here is the price in Canadian Dollars (CAD) on the TSE at the time of writing: 

And here is the price in US Dollars (USD) on the NYSE at the time of writing:  

Notice that the price is lower in USD. 

But using the exchange rate at the time, $33.71USD is actually $45.86 CAD. The prices are the same.

Investors are paying the same amount for Suncor on two independent stock exchanges. This supports semi-strong efficiency. 

Example Tres: Rising Stocks During Recession

Assume a recession is coming and investors expect GDP to drop by 3%. They all sell stocks in anticipation of falling earnings. The stock market drops in anticipation.

But as the recession starts, investors realize that the recession is not as bad as originally anticipated.

With this new information, investors buy more stocks and the prices go up. So, the stock market is rising as the recession is deepening.

Without EMH, it would look very weird to see stocks rising while GDP is falling.

This example highlights that markets are forward-looking. All available information and predictive power are priced into stock and bond markets.

  • Future interest rate increases? Priced in.
  • Future inflation expectations? Priced in.
  • Recession intensity? Priced in.

Prices only change when new information becomes available that changes the aggregate investor expectations for the future.

Efficient Markets and Index Investing

Markets are “efficient enough” that it is hard to beat the market. 

This is why I just own the market via low-cost total market index funds. With this approach, I am guaranteed the market return, less the small fees of ~0.1%.

And I’m talking about total market index funds. Not the array of active funds that are concentrated in specific sectors like EVs & Cannabis.

Market efficiency motivates index investing, but so do other factors like the skewness of stock returns and the concept of diversification. I cover diversification in this post on risk. 

For more on index investing, you can read Index Funds: A Simple Way To Invest In Stocks. 

Active Investors Make The Market Efficient

This one is interesting. Efficient markets motivate index investing, and active investors make the market efficient. Logic says that active investors motivate index investing. 

The active investors are out there exploiting mispricing by buying and selling. By doing so, they embed new information in asset prices. 

Active investors are paid for their work in exploiting mispricing errors, in the form of excess returns. 

I find capital markets fascinating due to their self-regulating nature. Natural incentives exist to ensure the proper pricing of millions of assets. Adam Smith called this mechanism the “invisible hand”.

Should too many investors jump into index funds, the market would be less efficient, and there would be more incentive to pick individual stocks. Passive index investors would migrate to active investing to earn a profit.

Therefore, the invisible hand creates an equilibrium between passive and active investors.

Eugene Fama and The Efficient Market Hypothesis

Eugene Fama is the godfather of the efficient market hypothesis, just like John Bogle is the godfather of index investing.  

It started in 1970, with Fama’s pivotal paper on EMH titled “Efficient Capital Markets: A Review of Theory and Empirical Work”.

In this paper, he talks about “strong form” efficiency and “weak form” efficiency and shows that markets are quite efficient. 

Fama then went on to build the 3-factor model and the 5-factor model that guided modern portfolio theory. 

Not many have had such an intense impact on finance. I had to mention Fama in this post. 

Efficient Markets And Human Behavior

I am excited to throw an interesting wrench into EMH.

Market efficiency assumes that humans will use the information to rationally price stocks based on the asset’s future cash flows and the risk of those cash flows. But are investors rational?

I’m not sure, and neither is the academic community.  

We have market bubbles, and crazes like GameStop, ARKK, and crypto runs. Crashes tend to overshoot and bounce back intensely. I’m convinced that the intensity of market swings is amplified by herding behavior. 

But it’s easy to say markets are “inefficient” in hindsight. Even if you are in a bubble, you never know when it will end. 

According to Daniel Kahneman’s prospect theory, defined in Thinking Fast and Slow. Humans are loss averse and susceptible to herding effects. There is a whole domain of study called behavioral economics. 

I resolve this issue by assuming that markets are efficient. It simplifies my investing, and my life.

Small Cap Value: Risk or Inefficient Markets?

Small-cap value stocks (stocks with low price-to-book ratios) have outperformed the market historically, both in the US and internationally. 

Here are US Small-Cap Value returns vs. Total US Market returns. You can see that small-value stocks, as a group, have beaten the US market by 3% annually for the last 50 years. Most of this outperformance occurred in the 70’s and 80’s. 

Do the excess returns stem from behavioral errors?

Value stocks are companies with high debt rations and risky future earnings. These companies usually are not doing very well at all. 

Maybe people are just loss-averse and afraid to buy these value stocks, resulting in underpricing and excess returns. In this case, the excess returns come from inefficient pricing.  

Or, is there an independent risk premium for value stocks? These businesses are riskier. Perhaps investors are getting compensated for taking on more investment risk. In this case, the market would be rational, and efficient. 

The source of excess SCV returns may be rational (based on risk). Or it may be irrational, rooted in human behavioral biases. I’m not sure, but it’s interesting to think about. 

Other Factors Related to EMH

I have other thoughts on EMH that don’t fit well in the structure of the article. I put them here. 

  • Information technology results in faster info flow in the modern world. Plus, there are computerized algorithms that trade based on the news.  Markets are far more efficient today than they were a few decades years ago. 
  •  Markets are never perfectly efficient. Perfect efficiency is only a “theoretical” state that can be approached but never reached.
  • The more efficient markets are, the harder you need to work to beat the market.
  • You can still get lucky in an efficient market. New surprising info can become available that was impossible to predict ahead of time. Then you will beat the market. 

Conclusion

To beat the market, you need to:

  • Act faster than other investors; or
  • Have information that others are missing.

In a perfectly efficient market, attempts to beat the market are a colossal waste of time. Total market index funds are the natural response in this “perfect” case. 

But the market is never perfectly efficient, and perhaps you want to beat the market. That seems reasonable. 

The next step is to ask if the juice is worth the squeeze. Is your time allocated to exploiting misinformation worth the benefit? Consider the time spent researching and managing a portfolio of over 30 individual stocks. 

I assess the market as being efficient enough that it’s not worth my time to try to beat the market. I don’t have better information than other investors, and my time is better spent increasing income, maintaining relationships, and staying in shape. 

Plus, I love the simplicity of total market index investing. It protects me from my own human biases. I have a good friend that calls this  “saving yourself from yourself “.

This insight, although humbling, helps you avoid situations that place high demands on self-discipline (the key to building wealth)

There are many other reasons that back the fact that simplicity is important to build wealth. 

Finally, EMH is the foundation of the self-regulating nature of capital markets. Active investors are paid, via excess returns, to exploit mispricing. This incentive keeps markets efficient and sustains a balance between active and passive investors. 

I hope you learned something that will help you make more efficient decisions. 

Jake out.

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