A Not-So-Efficient-Market Hypothesis

Of course, active traders of these instruments are thumbing their noses at the thesis.

What's Wrong With the Efficient Market Hypothesis?

That a theory has managed to survive and even thrive despite a wealth of evidence to the contrary is a testament to its intellectual elegance. A key to the EMH theory is the random nature in which information comes at investors, and the assumption that prices adjust almost immediately to reflect such information. This is behind the core thesis that no manager or asset class should be able to consistently outperform the market. Yet some studies demonstrate that value stocks have outperformed growth stocks. This shouldn't happen if markets are truly efficient.

That's a major problem the hypothesis has never adequately addressed. Many fund managers have outperformed the market. The responses of efficient market theorists have never been satisfying. They claim that chance or mere short-term market swings explain such outperformance. Theoretically, managers such as Warren Buffett, Peter Lynch and Bill Miller, along with many trend-followers, should not outperform the market over such long periods of time.

And yet they have.

A second problem with the efficient market hypothesis is the same flaw underlying so much of classical economic theory, and that's the rational man. We know markets can be flawed because of the emotions and analytical failures of its human participants. This leads to irrational price swings, crashes and bubbles -- events that shouldn't occur if prices reflect all known information about stocks.

The Wall Street Journal recently reported that Professor Fama has "adjusted" his thinking on EMH. In May he presented a paper at a conference in his honor and surprised many in the academic world. Fama made the case that "poorly informed investors could theoretically lead the market astray." Stock prices, he said, could become "somewhat irrational."

The professor is finally acknowledging something that all good traders know intuitively: the inherent fallibility of investors. Human beings are highly imperfect organisms as speculators in the capital markets. Thomas Gilovich points out a myriad of flaws in human decision-making in his seminal book, How We Know What Isn't So. We are impatient, given to bouts of fear and greed, make frequent analytical errors, suffer from bad data interpretation, overemphasize recent data and overrate our own abilities.

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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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