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The efficient market hypothesis argues that current stock prices reflect all existing available information, making them fairly valued as they are presently. Given these assumptions, outperforming the market by stock picking or market timing is highly unlikely, unless you are an outlier who is either very lucky or very unlucky.
Understanding the Efficient Market Hypothesis
The most important assumption underlying the efficient market hypothesis is that all information relevant to stock prices is freely available and shared with all market participants.
Given the vast numbers of buyers and sellers in the market, information and data is incorporated quickly, and price movements reflect this. As a result, the theory argues that stocks always trade at their fair market value.
Followers of the efficient market hypothesis believe that if stocks always trade at their fair market value, then no level of analysis or market timing strategy will yield opportunities for outperformance.
In other words, an investor following the efficient market hypothesis shouldn’t buy undervalued stocks at bargain basement prices expecting to see large gains in the future, nor would they benefit from selling overvalued stocks.
The efficient market hypothesis begins with Eugene Fama, a University of Chicago professor and Nobel Prize winner who is regarded as the father of modern finance. In 1970, Fama published “Efficient Capital Markets: A Review of Theory and Empirical Work,” which outlined his vision of the theory.
Three Variations Of the Efficient Market Hypothesis
Investors who strongly believe in the efficient market hypothesis choose passive investment strategies that mirror benchmark performance, but they may do so to varying degrees. There are three main variations on the theory:
1. The Weak Form of the Efficient Market Hypothesis
Although investors abiding by the efficient market hypothesis believe that security prices reflect all available public market information, those following the weak form of the hypothesis assume that prices might not reflect new information that hasn’t yet been made available to the public.
It also assumes that past prices do not influence future prices, which will instead be informed by new information. If this is the case, then technical analysis is a fruitless endeavor.
The weak form of the efficient market hypothesis leaves room for a talented fundamental analyst to pick stocks that outperform in the short-term, based on their ability to predict what new information might influence prices.
2. The Semi-Strong Form of the Efficient Market Hypothesis
This form takes the same assertions of weak form, and includes the assumption that all new public information is instantly priced into the market. In this way, neither fundamental nor technical analysis can be used to generate excess returns.
3. The Strong Form of the Efficient Market Hypothesis
Strong form efficient market hypothesis followers believe that all information, both public and private, is incorporated into a security’s current price. In this way, not even insider information can give investors an opportunity for excess returns.
Arguments For and Against the Efficient Market Hypothesis
Investors who follow the efficient market hypothesis tend to stick with passive investing options, like index funds and exchange-traded funds (ETFs) that track benchmark indexes, for the reasons listed above.
Given the variety of investing strategies people deploy, it’s clear that not everyone believes the efficient market hypothesis to be a solid blueprint for smart investing. In fact, the investment market is teeming with mutual funds and other funds that employ active management with the goal of outperforming a benchmark index.
The Case for Active Investing
Active portfolio managers believe that they can leverage their individual skill and experience—often augmented by a team of skilled equity analysts—to exploit market inefficiencies and to generate a return that exceeds the benchmark return.
There is evidence to support both sides of the argument. The Morningstar Active vs Passive Barometer is a twice-yearly report that measures the performance of active managers against their passive peers. Nearly 3,500 funds were included in the 2020 analysis, which found that only 49% of actively managed funds outperformed their passive counterparts for the year.
On the other hand, looking at the 10-year period ending December 31, 2020 shows a different picture, since the percentage of active managers who outperformed comparable passive strategies dropped to 23%.
Are Some Markets Less Efficient than Others?
A deeper look into the Morningstar report shows that the success of active or passive management varies considerably according to the type of fund.
For example, active managers of U.S. real estate funds outperformed passively managed vehicles 62.5% of the time, but the figure drops to 25% when fees are considered.
Other areas where active management tends to outperform passive—before fees—include high yield bond funds at 59.5% and diversified emerging market funds at 58.3%. The addition of fees for portfolios that are actively managed tends to drag on their overall performance in most cases.
In other asset classes, passive managers significantly outperformed active managers. U.S. large-cap blend saw active managers outperform passive only 17.2% of the time, with the percentage dropping to 4.1% after fees.
These results seem to suggest that some markets are less efficient than others. Liquidity in emerging markets can be limited, for example, as can transparency. Political and economic uncertainty are more prevalent, and legal complexities and lack of investor protections can also cause problems.
These factors combine to create considerable inefficiencies, which a knowledgeable portfolio manager can exploit.
On the other hand, U.S. markets for large-cap or mid-cap stocks are heavily traded, and information is rapidly incorporated into stock prices. Efficiency is high and, as demonstrated by the Morningstar results, active managers have much less of an edge.
How Star Managers Handle Their Portfolios
Popular investment manager Warren Buffet is one successful example of an active investor. Buffet is a disciple of Benjamin Graham, the father of fundamental analysis, and has been a value investor throughout his career. Berkshire Hathaway, the conglomerate that holds his investments, has earned an annual return of 20% over the past 52 years, often outperforming the S&P 500.
Another successful public investor, Peter Lynch, managed Fidelity’s Magellan Fund from 1977 to 1990. With his active investment ideology at the helm, the fund returned an average 29% annually and, over the 13-year period, Lynch outperformed the S&P 500 eleven times.
By contrast, another legendary name that stands out in the investment world is Vanguard’s Jack Bogle, the father of indexing. He believed that over the long term, investment managers could not outperform the broad market average, and high fees make such an objective even more difficult to achieve. This belief led him to create the first passively managed index fund for Vanguard in 1976.
The Efficient Market Hypothesis and Other Investment Strategies
Strong belief in the efficient market hypothesis calls into question the strategies pursued by active investors. If markets are truly efficient, investment companies are spending foolishly by richly compensating top fund managers.
The explosive growth in assets under management in index and ETF funds suggests that there are many investors who do believe in some form of the theory.
However, legions of day traders depend on technical analysis. Value managers use fundamental analysis to identify undervalued securities and there are hundreds of value funds in the U.S. alone.
These are only two examples of investors who believe that it is possible to outperform the market. With so many professional investors on each side of the efficient market hypothesis, it’s up to individual investors to weigh the evidence on both sides and to reach a conclusion about the efficiency of the financial markets that best matches their investing beliefs.