The Efficient Market Hypothesis and Indexing

We will get slightly more theoretical in this article, but we`ll keep it simple and brief!

The Efficient Market Hypothesis (EMH) states that stock prices perfectly reflects information currently available. The market is therefore perfectly efficient at pricing an asset. As the output of new information is, by nature, random (could be positive or negative, and to varying degrees) it would be impossible to predict the future trends of a stock by either technical or fundamental analysis. While this is simply a hypothesis (and one that does not come without controversy) it is interesting to discuss and see how it relates to index investing.

Following the hypothesis that the market is perfect at pricing a stock under the current conditions, trying to pick a winning stock (one that is undervalued) is a loser’s game. Beating the market would therefore be impossible. An investor would be best off investing in an index fund and enjoying normal market returns while minimizing fees.

The controversy comes from certain fundamental conditions or examples in the real world that challenge statements and assumptions of EMH, for example:

• The response time to new information varies, and therefore perhaps some edge can be gained by responding to new information faster than others.
• Information (and stock valuation) is not viewed the same by all investors, thus there is not a linear translation from information interpretation to stock pricing.
• Potential in human errors or emotions in influencing stock prices provide an additional element that the EMH does not account for. 
• Some proven investors do exist, such as Warren Buffet, that have consistently beaten the market over a long period of time.

While these concerns definitely hold weight, the market is becoming progressively more efficient in terms of response time to new information given how easy it is to trade stocks. This reduces the window of possibility for timing edges. There are also such a large number of investors participating in the market that if we assume information perspective (and stock valuation by individuals) is random, then the distribution of these random perspectives would average out to agreeing with EMH. This leaves emotional aspects, which contributes to variance in the market. Having said that, human emotions can also be viewed as random and thus making stock picks based on predicting human emotions would also be a loser’s game! Now there are definitely some stock pickers such as Warren Buffet that have disproven the EMH by being long-term winners in the market. As a Warren Buffet could simply not exists under the EMH.

Likely the EMH as a framework holds weight but it is influenced by some factors such as those mentioned above, which can challenge the legitimacy of the hypothesis during their extremes. Either way, it does reflect the high degree of randomness involved in trying to beat the market. Even if an exceptional investor continues to hold a winning strategy in beating the market, there would be high variance in the performance outcome due to vast uncertainties from randomness. As human beings are generally not good at dealing with uncertainties, investing in index funds may very well be the best strategy for the vast majority of investors.

Thank you for reading, if you have an topic recommendations please comment below!

Source: Dilbert

-Yinvestors.