Efficient Markets Hypothesis

The Efficient markets hypothsis (EMH) is an organizing principle for understanding how markets work and what investors should care about. Professor Eugene F. Fama of the University of Chicago performed extensive research on stock price patterns. In 1966, he developed the hypothesis, which asserts that:

• Securities prices reflect all available information and expectations.

• Current prices are the best approximation of intrinsic value.

• Price changes are due to unforeseen events.

• Stock prices follow a random walk and are not predictable.

• Although stocks may be mispriced at times, this condition is hard to recognize.

The EMH was a revolutionary concept. If true, it meant that it was not possible to predict future prices of securities. It meant that in order to do so, one would need to be a prophet with the ability to predict future events.

The concept of efficient securities prices is difficult for most investors to accept, and no wonder! Almost everything we buy and sell in the course of our daily lives is mispriced, or inefficient. For example, when buying a home, we may get a “good deal”. This can only come about if there are very few potential buyers. If there were millions of prospective buyers, many of whom did inspections of the house, any lowball bid would be eclipsed by higher offers and the result would be a selling price that is close to the intrinsic value of the home.

This is exactly what happens in the securities markets. Millions of potential buyers and sellers of publicly traded securities evaluate them. All of the known positive and negative information surrounding a security is reflected in a consensus price. In addition, the collective optimism or pessimism surrounding the security is reflected in the current price.

The EMH is very bad news for stock pickers and market forecasters. It means that there are no “deals” in the securities markets. Millions of market participants are constantly scrutinizing the price of securities, resulting in consensus market prices that are a fair representation of intrinsic value. The only way to predict future prices is to predict future events that no one else is aware of.

The EMH has been put to the test. If it is false and it is indeed possible to forecast prices, professional investors and mutual fund managers who employ large staffs of stock analysts and who are at the top of their field should have been able to outperform the average investor as measured by indexes.

Mike Jensen in the sixties and Mark Carhart in the nineties both conducted exhaustive studies of professional investors. They each concluded that in general a manager’s fee, and not his skill, plays the biggest role in performance. Since mutual funds report performance after deducting fees, the bigger the fee, the worse the performance on average. Aside from that, expert investors with nearly unlimited resources working around the clock can’t seem to out-predict the market.