Are Stock Markets Efficient or Not?
Your Investing Questions Answered
Moneycone asked, “Are markets efficient or not?”
After spending a few minutes thinking about how I would tackle this widely researched topic, I decided to do what any researcher would do, I opened a “google chrome incognito window” and typed in, “Are markets efficient or not?”
218 million responses later I am no less daunted. This question is one of the most widely debated investing questions.
What is the Efficient Market Hypothesis?
The efficient market hypothesis was created by one of this years Noble prize winners, Eugene Fama.
According to Morningstar.com the efficient market hypothesis is:
“A market theory that evolved from a 1960’s Ph.D. dissertation by Eugene Farma, the efficient market hypothesis states that at any given time and in a liquid market, security prices fully reflect all available information. The EMH exists in various degrees: weak, semi-strong and strong………. This theory contends that since markets are efficient and current prices reflect all information, attempts to outperform the market are essentially a game of chance rather than one of skill.”
The Three Types of Efficient Market
The efficient market hypothesis (EMH) is broken down into the “weak form” which states that stock prices reflect all publicly available information. The “semi strong form” of the EMH includes the weak form and adds that stock prices also adjust rapidly to the release of all new public information. Practically, this means that stock prices adjust so quickly to information that investors can’t profit from technical analysis (analyzing past stock price trends and movements) or even from fundamental analysis.
The third type of the EMH, the “strong form” includes the weak and semi strong and adds on insider information. If the markets were “strong form” efficient, then investors couldn’t profit from securing insider information. We know that markets are not “strong form” efficient because it is so widely accepted that investors can profit from insider information, that it is illegal to trade on insider information.
So we’ve ruled out the possibility that markets are “strong form” efficient, but are they weak or semi-strong form efficient? In other words, can investors make a profit greater than is expected by the riskiness of the security?
The index fund industry, spearheaded by John Bogle and Vanguard Investments states that investors are well served to invest in a diversified portfolio of index funds and that they will beat active and professional investors most of the time.
This sounds almost too simple to be possible, and there is loads of research that supports that finding. Yet, not everyone buys into the simple EMH theory, including one of this years other Nobel prize winners, Robert Shiller.
Efficient Market Hypothesis Controversy
If markets were proven to be completely efficient, then no investors would look to exploit market inefficiencies.
Shiller challenges the EMH with evidence that markets move away from their fair price and create over or undervalued scenarios. Think about the internet bubble of the late 1990’s. Stock average PE (price earnings) ratios sky rocketed driving prices way above fair value as defined by companies’ underlying business models. Shiller was among the forecasters who warned us about overvalued assets during the dot com boom and the more recent housing price bubble of the middle of last decade.
Market anomalies may also cause question about the efficient market hypothesis. These anomalies seem to persist over the long term in financial markets. (Be aware that they may persist over the long term, but in short periods of time there is not consistency to support that the market anomalies always “outperform”)
Momentum– A stock going up in price usually continues to go up (or down) even past the point of “fair value”.
Value Stocks-Lower valued stocks usually appreciate more than over valued stocks.
Small Cap Stocks-Small cap stocks usually outperform larger capitalization stocks.
The January Effect-Stocks usually go up in January.
But, do these anomalies disprove the efficient market hypothesis or are there logical explanations that explain the incidence of out performance other than the fact the markets are not efficient?
Why Market Anomalies Don’t Disprove the Efficient Market Hypothesis
The Investor’s Business Daily founder, William O’Neil is a big proponent in the momentum approach and it is true that for a period stocks do seem to continue moving in the same direction. Frequently, investors overreact to a positive or negative news incident and the stock price deviates from fair value. The problem with making an outsized gain, above that predicted by markets, is persistency.
Can an investor, over time, beat the EMH by investing in momentum stocks? It is unlikely, because at some point, momentum stops and share price returns to fair value. A successful momentum investor must be correct twice; when to get in and when to sell.
Stock prices can get beaten down by one time occurrences or other random factors that will not persist over the long term. By taking advantage of these periodic drops in value, when the stock rebounds to full value, the investor profits. Of all the market anomalies, this one makes the most sense to me.
Small stocks usually grow faster than large stocks. Practically speaking, if a company sells $10 billion per year, in order to grow 10% they would need to sell $100 million more in the next year. That’s a lot of sales.
But, if a company sells $5 million in a year, they only need to increase sales by $500 thousand in order to grow 10%. Earning $500 thousand is much easier than selling $100 million more products or services. Thus it is only logical that a small company is going to grow faster than a larger one.
At the end of the the year, many investors sell stocks with losses in order to benefit from the capital loss on their taxes. Thus, in January, they buy back stocks to remain in the markets. Simple explanation for the January effect.
Are Markets Efficient or Not?
I’ve taught the “efficient market hypothesis” in the Investments class at Santa Clara University and Lebanon Valley College for about 5 years. The conclusion is not a simple one.
If investors could make a profit greater than market returns most of the time, that would disprove the efficient market hypothesis.
Can investors outperform markets over the long term without taking outsized risk (out without being overly lucky) and continue to beat the markets year after year?
But, if there are investors beating the markets year in and year out, without taking large risks, they probably aren’t telling. After all, if these extraordinary investors divulge their methodology, then their advantage would disappear. Maybe a few investors such as Warren Buffett or George Soros beat the odds, but not many.
The Investing Takeaway
After decades of investing in the markets, picking stocks, and index funds, I’m convinced that over the long term an index fund approach, in line with one’s risk tolerance is the most effective way to invest. It’s not too time consuming and market returns are good.
Stocks have averaged about 9% over the last 80 years or so and bonds about 5%.
If you do want to try to outperform the markets, go with indexing for the majority of your portfolio and invest 10 to 15% of your financial assets with an active strategy.
Don’t miss Investing Questions Answered
What is your opinion? Are markets efficient or not? Do you use index funds or actively manage your investments?
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