Random walkers (people who argue price variations in financial markets are random) are everywhere. You can find them as financiers, economists, and even wealth managers! In fact, they are proponents of the efficient market hypothesis, also known as efficient market theory.

 

The Efficient Market Hypothesis

 

The Efficient Market Hypothesis (EMH) is popular in financial economics. The theory states that stock prices reflect every piece of information, making the generation of alpha in investing nearly impossible.

 

In other words, stocks always trade at their fair value and price on exchanges, and investors can’t invest in undervalued stocks or sell overvalued stocks. So, it is impossible to ‘beat’ the market using stock picking or market timing strategies. The only way for an investor to generate higher returns is by buying riskier investments or passive investing.

 

On the flip side, opponents of EMH strongly believe that it is possible to beat the market as stocks can deviate from their fair market values and prices.

 

Sounds confusing, isn’t it? If EMH is true, investors like Rakesh Jhunjhunwala or Warren Buffett wouldn’t be successful in making their billions. If no one can beat the market, how could some people successfully use trading to generate profit? As per EMH, an ideal investing approach should be to invest in a long-term passive fund and forget about it, rather than wasting your time and intelligence on stock market research and stock picking.

 

Although the theory is conflicting, the efficient market hypothesis has a popular following in financial economics. Here we discuss the relevance of this popular economic theory and look at how this theory can make an impact on current market conditions.

 

Various Forms of Efficient Market Hypothesis

 

According to the efficient market theory, investors tend to act randomly and illogically. Therefore, the market is always ‘right’ or ‘efficient’ as a whole; ‘efficient’ in a sense, ‘normal.’ For example, if a crowd starts running in a particular direction, there arises a natural tendency to follow the group, even if there is no compelling reason to do so.

 

There are three primary forms of EMH, and they are described below.

 

1. Weak Form

 

The weak form of EMH suggests that every stock reflects past information. Therefore, fundamental and technical analysis of stocks may give you information (not valuable ‘patterns’) to achieve short-term returns that are higher than average market returns. In a plain sense, it means that neither fundamental nor technical analysis will give a long-term benefit for the investor, but they have a chance to generate returns in the short term.

 

2. Semi Strong Form

 

According to semi-strong EMH, neither fundamental nor technical analysis helps you ‘beat’ the market. But with insider information, you can reap extraordinary gains.

 

3. Strong Form

 

In the strong form of EMH, no extraordinary gains can be realized because all present and past information (even the insider information) is adjusted to the current stock price. As all information is known to every market player, no investor can reap better returns than average market returns.

 

Although EMH claims that outperforming the market is nearly impossible, the theory claims that outliers can ‘beat’ the market at some point. While some outliers lose tons of money in the market, most investors stand closer to the median. In short, the instances of beating the market are nothing short of sheer luck.

 

The practicality of the Efficient Market Hypothesis

 

The proponents of the efficient market hypothesis are also proponents of passive investing as they do not believe in active investing. So, they believe in ‘slow and steady wins the race’ and invest in passive index funds with a long-term perspective. This investment approach gives them only what the market has to offer.

 

When market players increase, the market becomes more efficient as more players bring more information. This increase in data has a more significant impact on the stock prices. The entry of more market players makes markets more transparent. When markets evolve, becoming more active and liquid, it leads to the emergence of arbitragers who will correct minor price anomalies in the short run.

 

Can Markets be Inefficient?

 

Now let’s look at an inefficient market. While an efficient market feeds all the available information into the stock prices, inefficient markets fail to provide the information into the stock price although it has all the information.

 

Some of the characteristics of inefficient markets are their non-transparent nature, higher transactional costs, and fewer market players. In addition, a few market players in an inefficient market possess an edge to easily beat the market and generate hefty returns. That also means a few traders or investors can easily fool most investors. Inefficient markets are volatile and not subject to proper regulation by a regulatory body like the Securities and Exchange Board of India (SEBI).

 

Conclusion

 

The efficient market theory didn’t gain popularity until the 1960s when the emergence of computers made it possible to quickly compare and calculate the prices of thousands of stocks. In 1945, Friedrich Hayek, an Austrian economist, argued that markets are the most effective way of aggregating the pieces of information dispersed among individuals in a society. Self-interested traders, on the other hand, may try to profit from private data. But, in doing so, they contribute to more efficient market prices as their trades reflect in the stock or market prices.

 

Legendary investors such as Warren Buffett, George Soros, and several prominent researchers have disputed EMH both empirically and theoretically. Nevertheless, imperfections in financial markets exist, and behavioral economists attribute it to a combination of human cognitive biases like overconfidence, overreaction, representative bias, and information bias, including several other predictable human errors in information processing and reasoning. These human psychological factors are researched by prominent economists like Richard Thaler and famous psychologists like Daniel Kahneman, Amos Tversky, and Paul Slovic.

 

Market efficiency is the quality that is needed for any developed economy. But unfortunately, financial markets may not give an opportunity to earn supernatural returns. Still, by use of portfolio management and risk profiling, a higher return than the average market returns can be attained.

 

Justin Raj

 

Alpha Research