Tell Me Again the Tale of the Efficient Market Hypothesis
Things They Forgot To Tell Me In Business School

Watching my investment portfolio continue its awkward gyrations the other day I got to thinking, not about the stocks jumping around during an unprecedented global crisis, I get that, of course, they do, would be strange if they didn’t, but rather about all the reasons why they shouldn’t.
 
What I got to thinking about was one of the truly big Things They Forgot To Tell Me in Business School: how far observed reality in the financial markets differs from the theoretical foundations of the financial system itself. In other words, I am once again awed with the yawing gulf between capitalism as it is versus capitalism as it should be, and would have like to have been given a heads up on this.
 
Take the enduring importance of the Efficient Market Hypothesis (EMH). For anyone who has not sat through an introductory finance class, the Efficient Market Hypothesis is the keystone of all modern risk-based asset pricing theories. It hypothesizes pretty much what it says on the label:
 
· Efficient Market Hypothesis: exchange-traded stocks always trade at fair value because asset pricing accurately reflects all available information commonly valued, with trades executed by rational market actors. In this environment, prices move only in response to additional information.
 
Lots to unpack here, but basically, in an efficient trading market, it is impossible to outperform the market over time through selective investment or market timing, only by taking on investments of higher risk which earn higher returns on their own merits. There is no such thing as «price momentum», and bubbles don’t form then burst.
 
In effect, asset pricing and trading models are built directly on assumptions of transparency and rational human behavior. Or, more likely today, asset pricing and trading models are built on statistical corrections to faulty assumptions of transparent and rational human behavior. Let all that sink in for a minute.
 
It is impossible to overstate the influence this theoretical construct, the Efficient Market Hypothesis (EMH), has had in shaping the financial system around the world today. Nobel prizes have been awarded in its honor, to Dr. Eugene Fama and Lars Peter Hanson in 2013. In fact, EMH is so crucially influential that a Nobel prize was also awarded to Dr. Robert Stiller in the same year for criticizing the theory.
 
And it is hard to exaggerate the importance of asset pricing models to all of us, whether we are active stock traders or not. The value of stocks traded across the world annually varies greatly but is in the range of USD $75,000,000,000,000 [USD 75 Trillion], just shy of the size of the entire global economy (weforum.org), and the behavior of stock trading markets critically influences all aspects of economic life.
 
One of the reasons the Efficient Market Hypothesis [EMH] has been so successful and enduring is that it is the economic equivalent of a universal climbing wall - an enormous convenience concocted by very clever economists who realized that presumptions of efficient rational behavior come with normally distributed data, a constant variance of residuals, etc., greatly facilitating statistical analysis.
 
Call it one of life’s necessary inexplicables. As such, you can lump EMH in with evolution, another theory I am quite fond of, which operates a similar «just give me one small miracle, the spark of life, and I will explain the rest». For EMH we just need to accept rational markets as our one small miracle. Unsurprisingly, interest in this theory, which had been kicking about in one form or other without great success for decades, rose greatly during the 1960s with the advent of large-scale computer data modeling. It is then that it seized the crown which it has never fully relinquished.
 
A second reason Efficient Market Hypothesis has been so successful and enduring is that it is also the economic equivalent of a huge stake in the ground, a survey pin, a common reference point that all can identify if only to take aim at and reject. As such, it is also like democracy, another perennial favorite of mine, aptly summed up by Winston Churchill with «No one pretends that democracy is perfect or all-wise. Indeed it has been said that democracy is the worst form of Government except for all those other forms that have been tried from time to time.…». So in many ways, EMH carries on because nothing is broadly enough accepted as better to replace it.
 
Behavioral economists demonstrate that humans bring cognitive biases into the equation, value investors make a living focusing on fundamentally «under-priced» assets, automated trading systems can trigger on trading patterns rather than additional information, technical analysts look back to take a running jump forward, a most un-random of walks, and innumerable proprietary trading models do their thing. But these are just side-shows, each with their own partisans, providing counterpoints to the efficient market, and possibly being very effective, but failing to define a new paradigm.
 
A third reason that the Efficient Market Hypothesis has been so successful and enduring is flexibility. Like the best of organized religions, many take it seriously but none take it literally. Even proponents hedge their bets, classifying it into strong-form, semi-strong form, and weak-form. Strong form contends that stock prices account for all available information past and present, public and private. It is the spiritual leader but not much in demand today. Semi-strong form contends that stock prices account for publicly available information past and present only, allowing that private information may not be factored in [MNPI - material non-public information]. A little space to breathe already. Weak-form contends that only current information influences stock prices reject all patterns and momentum in trading while promoting the random walk theory that daily price fluctuations are independent of each other and anything coming before. For each a different flavor.
 
So, as you watch stock markets react to current events in the most skittish and puzzling of ways, please spend a relaxing moment in suspended disbelief and swim in the calming waters of the Efficient Market Hypothesis, where all prices are true, all information is transparent and uniformly valued, and all the people rational.
 
;)