TheStreet

If you're considering investing in individual stocks, you should know about the economic theory known as the Efficient Market Hypothesis (or Theory), also known as EMH or EMT. Since the 2008-09 Great Recession, in fact, a number of market analysts have suggested individual investors should not try and pick stocks or other assets based on past performance, or even fundamental analysis, but instead invest in mutual funds tied to the various stock indexes. A belief that market efficiency is reflected in stock and other asset prices as well as indexes is the reason for such a recommendation.

What Is the Efficient Market Hypothesis?

The gist of EMH is that the prices of assets, such as stocks, reflect all available information about them. Which is a reason why "insider trading" is a crime - people with information not available to the general investing public have a distinct advantage over other investors.

If you were investing in the market, you would not be able to outperform it consistently over time, because EMH's main pillar is that prices reflect all available information about a stock - so the only way to outperform the market consistently would be if you had consistent access to information others didn't have. 

This is why new information - a headline that investors consider might have some bearing on a stock's individual performance, or even the market as a whole - is, by its nature, unexpected. Because stock prices, in the EMH, reflect all that is known at the time affecting a particular company or the market as a whole. And unexpected - or, more precisely, previously unknown - information causes individual stocks or markets to move in response. 

This is also why many investors and advisers consider "market strategies" to be wishful thinking. Because you cannot plan for market-moving news, and therefore any strategy will reflect what is known to all others, not what isn't. And prices will adjust to each piece of information relevant to a particular stock, other asset, or even industry.

With the advent and now heavy use of sharing of information on social media, with mobile devices like smartphones, and faster internet transmission and uploading speeds, theoretically, at least, markets are even more efficient, because new information becomes more rapidly and widely known, eliminating to a certain extent the ability of a few to have information others have no access to in making investment decisions. 

So the only way likely to outperform an industry or market index in terms of returns is to purchase higher risk investments. 

Jules Regnault, a stock broker's assistant, first proposed the idea of efficient markets in his 1863 book "Calcul des Chances et Philosophie De La Bourse," translated roughly to "Calculation of Chance and Philosophy of the Stock Exchange."

After Regnault, around 1900, French mathematician Louis Bachelier's Ph.D. thesis "The Theory of Speculation" described how and presumably why the prices of stocks and commodities varied in markets. In 1964, Bachelier's thesis was translated into English. 

A year later, Eugene Fama published his own dissertation, arguing that stock prices always traded at their fair value, so that investors can neither buy stocks that are undervalued, or sell ones at inflated prices. Fama's work was made possible with the use of computers to calculate and compare large sets of data to strengthen his argument. Fama, who was awarded the Nobel Prize in Economic Sciences in 2013 for his work, first mentioned "efficient markets" and "market efficiency" in a paper titled "Random Walks in Stock Market Prices" when he was at the Graduate School of Business at the University of Chicago. The "random walk" concept is based essentially on market efficiency, or the idea that specific stocks do not behave in any special way differently than others, and that all prices reflect "efficiency." 

The Three Main Variants of Efficient Markets Hypothesis

  • Weak Form Efficiency: The basis of "weak form efficiency" is, as the qualifying phrase to all investors by advisers always suggests: "past performance is no guarantee of future results." In other words, future prices cannot be predicted merely by reviewing past prices. So that excess returns - or improved returns - cannot be made over time basing investment strategy on historical share prices or other data.
  • Semi-Strong Form Efficiency: The basis of "semi-strong form efficiency" is that share prices adjust to publicly available new information quickly, and in an unbiased manner, so that no excess returns can be made trading on that information. A test of this is reviewing consistent upward or downward price adjustments after an initial piece of news hits. The movement and direction is believed to indicate if investors interpreted the news in a biased way, which is therefore "inefficient," or unbiased, which is "efficient." 
  • Strong Form Efficiency: In "strong-form efficiency," all share prices reflect the entirety of available information, both public and private, meaning no individual can make excess returns, or "beat the market." This form of market efficiency isn't possible where legal barriers exist to private information becoming public. An example of legal barriers to private information becoming public is insider trading laws. The only way in such an environment for strong-form efficiency is if barriers to private information becoming public are ignored, so that prices reflect private as well as public information. 

Positives and Negatives of EMH

Problems with the idea of Efficient Markets cited by critics lie in the area of behavioral science. First, individuals view market information differently. Second, markets as a whole can be sent into a "panic," based on no fundamental reason other than fear. And, third, a belief that investors are not "rational," in the sense that their decisions are not always based on publicly or even privately available information so much as their tolerance or lack of it for risk.

Fabled investor Warren Buffett argued back in 1984 that "there is much inefficiency in the market...When the price of a stock can be influenced by a "herd" on Wall Street with prices set at the margin by the most emotional person, or the greediest person, or the most depressed person, it is hard to argue that the market always prices rationally. In fact, market prices are frequently nonsensical."

Stocks take some time to respond to new information, so those who get the information first are in the best position to take advantage of it - which is why methods of distributing information, such as wire services, social media platforms, and regulations such as the U.S. Securities and Exchange Commission's "Full Disclosure," or Regulation FD, adopted in 2000, remain important to investors - and are designed to improve market efficiency.

According to the SEC, Regulation FD "addresses the selective disclosure of information by publicly traded companies and other issuers. Regulation FD provides that when an issuer discloses material nonpublic information to certain individuals or entities-generally, securities market professionals, such as stock analysts, or holders of the issuer's securities who may well trade on the basis of the information-the issuer must make public disclosure of that information. In this way, Regulation FD aims to promote the full and fair disclosure."

Critics have suggested, in fact, that the 2008-09 Great Recession, the result of a 2007-08 financial crisis which itself was sparked by an asset bubble in subprime mortgage lending, was the result of too heavy a reliance on EMH. For many critics, behavioral finance - an analysis of stock and other asset investing based on behavioral aspects or biases of investors - became popular in the 1980s as cracks appeared in beliefs in market efficiency.

But, in a paper published in 2003 by EMH advocate and American Economist Burton G. Malkiel at Princeton University, Malkiel - author of the popular 1970s stock market explainer "A Random Walk Down Wall Street" - argued that "our stock markets are far more efficient and far less predictable than some recent academic papers would have us believe. Moreover, the evidence is overwhelming that whatever anomalous behavior of stock prices may exist, it does not create a portfolio trading opportunity that enables investors to earn extraordinary risk adjusted returns."

So EMH is good to know about for investors considering a portfolio or 401(k) or other investing vehicle that tracks the markets rather than attempts to beat them. And those who believe, essentially, that a monkey throwing darts at a stock page could pick as good or as bad a portfolio as a much-touted stock adviser or "picker."