A Not-So-Efficient-Market Hypothesis

The efficient-market hypothesis, or EMH -- one of the most dominant theories of market behavior on Wall Street -- has been under attack for years. After several decades of dominance, now the theory is getting its comeuppance.

It's long overdue.

Adherents of the efficient-market thesis believe that markets distribute information nearly instantaneously. Prices theoretically incorporate and reflect all relevant information about any given stock, say EMH theorists. Because prices are random and unpredictable, active management is destined to underperform, and market-timing is predetermined to fail.

Or so the story used to go. There has been a slow recognition by many academics -- including University of Chicago Graduate School of Business Professor Eugene Fama, whom The Wall Street Journal calls "the intellectual father" of EMH -- that markets are far less efficient than previously believed. With the theory on the verge of finally succumbing, the repercussions for portfolio management and asset allocation strategies will be felt for years to come.

A walk down Wall Street is becoming much less random.

Why Should Investors Care About a Theory?

You are excused for thinking this is the sort of academic tomfoolery that only gets published in wonky economic journals for the egghead set. What possible impact might a mere theory have on your trading activity?

Actually, quite a lot. This is one of those instances where academics have had very real repercussions on markets. Indeed, the set of beliefs behind EMH has led to a number of significant changes in investor behavior, with far-reaching consequences:

• a shift toward passive index funds and away from active management or stock selection;
• a bias away from market-timing;
• a reinforcement of the "buy and hold" approach.

Efficient market theorists were the key drivers behind the rise of index funds. Consider that in October 2002, the Vanguard S&P 500 Index fund surpassed the actively managed Fidelity Magellan Fund to become the world's largest equity fund.

Passive management strategies are also behind the burgeoning demand for exchange-traded funds. If you own the Nasdaq 100 Trust (QQQ - commentary - Cramer's Take), Dow Diamonds Trust (DIA - commentary - Cramer's Take) or S&P 500 Depositary Receipts (SPY - commentary - Cramer's Take), you are indirectly engaging in the efficient market hypothesis.

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Barry Ritholtz is chief market strategist for Maxim Group, where his research and market analysis are used by the firm's portfolio managers and clients in the U.S., Europe and Japan. He also publishes The Big Picture, his macro perspectives on the economy and geopolitics, entertainment and technology industries. At the time of publication, Ritholtz had no position in any securities mentioned in this column, although holdings can change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Ritholtz appreciates your feedback and invites you to send it to [e-mail].

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