Today, I would like to talk about this important piece of information that I have learned in the beginning portion of my finance journey - The Efficient Market Hypothesis (EMH). This piece of information has served as a cornerstone in my investment approach and why I believe in ETFs rather than Mutual Funds. And I cannot wait to share this piece of information with you guys today.
Definition:
The efficient market hypothesis (EMH), alternatively known as the efficient market theory, is a hypothesis that states that share prices reflect all information, and consistent alpha generation is impossible. - Investopedia
The Efficient Market Hypothesis (EMH) essentially says that all known information about investment securities, such as stocks, is already factored into the prices of those securities - The Balance
There are different forms of EMH, which will be discussed later in the post. But I would like to highlight what the abovementioned definition means. This would mean that in an efficient market, no investor is able to consistently outperform the market (outperforming the market is alpha). In this article, I will be discussing the evidence for and against EMH, the different forms of EMH, how you can utilize EMH in your portfolio, and my personal thoughts and comments.
Evidence for EMH:
1. As was discussed in my previous look at the SPIVA papers, that shows very strong evidence for EMH. In the SPIVA paper, it has been shown that ~90% of mutual funds underperform their index/benchmark in a 15 years time horizon. Hence, we can see that in the long run (15 years), really low portion of active management approaches can outperform the market
2. Furthermore, as companies release their quarterly earnings reports, we can see that the stock prices are quick to reflect based on the report.
Evidence against EMH:
1. Just like how 90% of mutual funds underperform the market, there are actually 10% of the mutual funds that still outperform the market in the 15 years time horizon. However, I am unable to find a comparison in performance beyond 15 years.
2. Not just mutual funds, there are active investors that have outperformed the market over long time horizons like Warren Buffett, Peter Lynch, etc.
Forms of EMH:
1. Weak Form EMH:
This is when all past information is priced at the stock price. Hence, fundamental analysis of securities using P/E, PEG, Cashflow, Dividend growth allows for investors to produce returns above the market in the short term and there are no recurring "patterns" that an investor can take advantage of. Hence, technical analysis won't work and fundamental analysis would not work in the long run.
2. Semi-strong Form EMH:
New public information is instantly priced into the stock price. This would mean that fundament and technical analysis would not work at all (This is where it is a bit ridiculous. As we all know that new formation is not instantly reflected in the stock price, heard of insider trading?) - This covers for private information
3. Strong Form EMH:
Both public and private information are priced into the price. Hence, no investor can outperform the market.
It is important here to say that EMH is able to explain for a majority of the market investors. However, just as all models, there are abnormalities that fall outside of this model. Hence, there will be extreme winners and extreme losers in the stock market. However, as we do not take note of the extreme losers, it can affect our perception of the market that there is a chance to outperform the market.
How you can take advantage of the EMH:
1. Invest in super low-cost ETFs: This is such that you may take advantage of the EMH and stick to the market's performance as close as possible. (Low expense ratio) Passive investors' approach
2. Invest in inefficient markets: This is for markets that stock prices would not immediately change based on the news but it would take a few days. But with the advent of the internet, such markets are getting rarer and rarer.
Thoughts and comments:
You are aware of it already. I am a firm supporter of the EMH. This is especially after the long-term performance of ETFs trumping on mutual funds. Furthermore, it is almost impossible to judge if a mutual fund will outperform the market in the long run (except if it is done in hindsight *cough* shady practices *cough*.
Hence, I would always voice my support in ETFs due to their efficiencies and be disappointed as a majority of the market is still done by active investment. HOWEVER, more and more money in the market is going into passive investment. So.. I guess things are changing. And we are in the midst of this change.
Till then,
Stay vested, stay frugal my friends.
Dionysius
Sources:
https://www.investopedia.com/terms/e/efficientmarkethypothesis.asp
https://www.thebalance.com/efficient-markets-hypothesis-emh-2466619
http://static.stevereads.com/papers_to_read/the_behavior_of_stock_market_prices.pdf
https://us.spindices.com/indexology/core/spiva-us-year-end-2019
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