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The Efficient Market Hypothesis
& The Random Walk Theory

Gary Karz, CFA Follow GKarz on Twitter
Host of InvestorHome
Founder, Proficient Investment Management, LLC

     An issue that is the subject of intense debate among academics and financial professionals is the Efficient Market Hypothesis (EMH). The Efficient Market Hypothesis states that at any given time, security prices fully reflect all available information. The implications of the efficient market hypothesis are truly profound. Most individuals that buy and sell securities (stocks in particular), do so under the assumption that the securities they are buying are worth more than the price that they are paying, while securities that they are selling are worth less than the selling price. But if markets are efficient and current prices fully reflect all information, then buying and selling securities in an attempt to outperform the market will effectively be a game of chance rather than skill.

     The Efficient Market Hypothesis evolved in the 1960s from the Ph.D. dissertation of Eugene Fama. Fama persuasively made the argument that in an active market that includes many well-informed and intelligent investors, securities will be appropriately priced and reflect all available information. If a market is efficient, no information or analysis can be expected to result in outperformance of an appropriate benchmark. 1

"An 'efficient' market is defined as a market where there are large numbers of rational, profit-maximizers actively competing, with each trying to predict future market values of individual securities, and where important current information is almost freely available to all participants. In an efficient market, competition among the many intelligent participants leads to a situation where, at any point in time, actual prices of individual securities already reflect the effects of information based both on events that have already occurred and on events which, as of now, the market expects to take place in the future. In other words, in an efficient market at any point in time the actual price of a security will be a good estimate of its intrinsic value."
Eugene F. Fama, Random Walks in Stock Market Prices Financial Analysts Journal, September/October 1965 (reprinted January-February 1995).

     The random walk theory asserts that price movements will not follow any patterns or trends and that past price movements cannot be used to predict future price movements. Much of the theory on these subjects can be traced to French mathematician Louis Bachelier whose Ph.D. dissertation titled "The Theory of Speculation" (1900) included some remarkably insights and commentary. Bachelier came to the conclusion that "The mathematical expectation of the speculator is zero" and he described this condition as a "fair game." Unfortunately, his insights were so far ahead of the times that they went largely unnoticed for over 50 years until his paper was rediscovered and eventually translated into English and published in 1964. (See Peter Bernstein's Capital Ideas for more on these topics.)

     There are three forms of the efficient market hypothesis

  1. The "Weak" form asserts that all past market prices and data are fully reflected in securities prices. In other words, technical analysis is of no use.
  2. The "Semistrong" form asserts that all publicly available information is fully reflected in securities prices. In other words, fundamental analysis is of no use.
  3. The "Strong" form asserts that all information is fully reflected in securities prices. In other words, even insider information is of no use.

     Securities markets are flooded with thousands of intelligent, well-paid, and well-educated investors seeking under and over-valued securities to buy and sell. The more participants and the faster the dissemination of information, the more efficient a market should be.

     The debate about efficient markets has resulted in hundreds and thousands of empirical studies attempting to determine whether specific markets are in fact "efficient" and if so to what degree. Many novice investors are surprised to learn that a tremendous amount of evidence supports the efficient market hypothesis. Early tests of the EMH focused on technical analysis and it is chartists whose very existence seems most challenged by the EMH. And in fact, the vast majority of studies of technical theories have found the strategies to be completely useless in predicting securities prices. However, researchers have documented some technical anomalies that may offer some hope for technicians, although transactions costs may reduce or eliminate any advantage.

     Researchers have also uncovered numerous other stock market anomalies that seem to contradict the efficient market hypothesis. The search for anomalies is effectively the search for systems or patterns that can be used to outperform passive and/or buy-and-hold strategies. Theoretically though, once an anomaly is discovered, investors attempting to profit by exploiting the inefficiency should result its disappearance. In fact, numerous anomalies that have been documented via back-testing have subsequently disappeared or proven to be impossible to exploit because of transactions costs.

     The paradox of efficient markets is that if every investor believed a market was efficient, then the market would not be efficient because no one would analyze securities. In effect, efficient markets depend on market participants who believe the market is inefficient and trade securities in an attempt to outperform the market.

     Many believe that markets are neither perfectly efficient nor completely inefficient. All markets are efficient to a certain extent, some more so than others. Rather than being an issue of black or white, market efficiency is more a matter of shades of gray. In markets with substantial impairments of efficiency, more knowledgeable investors can strive to outperform less knowledgeable ones. Government bond markets for instance, are considered to be extremely efficient. Most researchers consider large capitalization stocks to also be very efficient, while small capitalization stocks and international stocks are considered by some to be less efficient. Real estate and venture capital, which don't have fluid and continuous markets, are considered to be less efficient because different participants may have varying amounts and quality of information.

The efficient market debate plays an important role in the decision between active and passive investing. Active managers argue that less efficient markets provide the opportunity for outperformance by skillful managers. However, its important to realize that a majority of active managers in a given market will underperform the appropriate benchmark in the long run whether markets are or are not efficient. This is because active management is a zero-sum game in which the only way a participant can profit is for another less fortunate active participant to lose. However, when costs are added, even marginally successful active managers may underperform. (See "The Arithmetic of Active Management" from Nobel laureate William Sharpe for more on this subject.)

I believe a third view of market efficiency, which holds that the securities market will not always be either quick or accurate in processing new information. On the other hand, it is not easy to transform the resulting opportunities to trade profitably against the market consensus into superior portfolio performance. Unless the active investor understands what really goes on in the trading game, he can easily convert even superior research information into the kind of performance that will drive his clients to the poorhouse . . . why aren't more active investors consistently successful? The answer lies in the cost of trading.

Jack Treynor, What Does It Take to Win the Trading Game? Financial Analysts Journal, January/February 1981

If markets are efficient, the serious question for investment professionals is what role can they play (and be compensated for). Those that accept the EMH generally reason that the primary role of a portfolio manager consists of analyzing and investing appropriately based on an investor's tax considerations and risk profile. Optimal portfolios will vary according to factors such as age, tax bracket, risk aversion, and employment. The role of the portfolio manager in an efficient market is to tailor a portfolio to those needs, rather than to beat the market.

While proponents of the EMH don't believe its possible to beat the market, some believe that stocks can be divided into categories based on risk factors (and corresponding higher or lower expected returns). For instance, some believe that small cap stocks are riskier and therefore are expected to have higher returns. Similarly some believe value stocks are riskier than growth stocks and therefore have higher expected returns.2

Contrary to majority opinion in university departments of finance, markets are not efficient; they are inefficient. Furthermore, the safest stock portfolios have the highest expected returns, and the riskiest portfolios have the lowest expected returns.
Robert Haugen in The Inefficient Market and the Potential Contribution of Behavioral Finance: Case Closed, June 2010

Faced with the inference that they cannot add value, many active managers argue that the markets are not efficient (otherwise their jobs can be viewed as nothing more than speculation). Similarly, the investment media is generally considered to be ambivalent toward the efficient market hypothesis because they make money supplying information to investors who believe that the information has value (beyond the time when it initially becomes public). If the information is rapidly reflected in prices, there is no reason for investors to seek (or purchase) information about securities and markets.

While many argue that outperformance by one or more participants in a market signifies an inefficient market, it's important to recognize that successful active managers should be evaluated in the context of all participants. Its difficult in many cases to determine whether outperformance can be attributed to skill as opposed to luck. For instance, with hundreds or even thousands of active managers, its common and in fact expected (based on probability) that one or more will experience sustained and significant outperformance. However, the challenge is to identify an outperformer before the fact, rather than in hindsight. (See Coin-Flipping & Graham-and-Doddsville and A Stock Market Scam for more on these topics.)

Additionally, in many cases, strong performers in one period frequently turn around and underperform in subsequent periods. A substantial number of studies have found little or no correlation between strong performers from one period to the next. The lack of consistent performance persistence among active managers is further evidence in support of the EMH. (See Do Past Winners Repeat? and Cherry-Picking).

There have been many cases of illogical stock market reactions to various announcements or conditions that critics of the EMH have cited. For instance, during the internet bubble, stocks adding ".com" to their name experienced seemingly illogical price appreciation following the annoucement. There have also been many cases where investors have traded the wrong stock following news (as discussed in Your Money & Your Brain). Jason Zweig noted a more recent example in his The Name Trap Interview and WSJ column on 3/19/10. Kee-Hong Bae and Wei Wang found China-name stocks significantly outperform non-China-name stocks in their study titled What's in a 'China' Name? A Test of Investor Sentiment Hypothesis.

Professor Robert Shiller has even gone so far as to say "The Efficient Market Hypothesis is one of the most egregious errors in the history of economic thought." See Using Behavioral Finance to Better Understand the Psychology of Investors (May 2010) from II. In the same article Andrew Lo (who proposed the Adaptive Markets Hypothesis, in which markets are neither efficient nor irrational, but some combination of both) states "There are periods when the market is highly efficient, and there are those that arenít . . . The better question is: What is the relative efficiency at a given point in time? That is something that can be measured."

"If academics are just saying that the efficient market hypothesis means the market is hard to outsmart, then, no, it has not been discredited at all. But if academics are saying that the efficient market hypothesis means markets behave rationally, then they do not have good explanations for what went on the past couple of years."

Justin Fox, author of The Myth of the Rational Market, in Are Finance Professors and Their Theories to Blame for the Financial Crisis? CFA Institute Conference Proceedings Quarterly (June 2010 ahead of print)

While critics are quick to point to the preceeding (and other) examples, there are plenty of other examples that strongly support the market efficiency argument. In one stunning example of the ability to market to quickly analyze an emotional and completely unexpected event (see The Stock Price Reaction to the Challenger Crash: Information Disclosure in an Efficient Market or here) Michael T. Maloney and Harold Mulherin found that "the market pinpointed the guilty party within minutes".

In Efficient Markets in Crisis in the Second Quarter of 2011 issue of the Journal Of Investment Management Professor Meir Statman (author of What Investors Really Want) elaborates on the debate about the financial crisis and market efficiency by defining informationally efficient markets, rational markets, random-walk markets, and importantly unbeatable markets. While markets may not be completely efficient, rational, and/or random-walk markets, and while markets may be beatable by some skilled money managers they still tend to be unbeatable to their clients because the cost of exploiting deviations is so high that those seeking positive alphas end up with zero or negative alphas net of costs. Statman summarizes that "A demise of the rational markets and the informationally efficient markets hypotheses does not necessarily imply the demise of the unbeatable markets hypothesis, since knowledge that bubbles exist does not necessarily imply that investors can identify them as they occur and generate positive alphas by trading on them."

"Market efficiency is a description of how prices in competitive markets respond to new information. The arrival of new information to a competitive market can be likened to the arrival of a lamb chop to a school of flesh-eating piranha, where investors are - plausibly enough - the piranha. The instant the lamb chop hits the water, there is turmoil as the fish devour the meat. Very soon the meat is gone, leaving only the worthless bone behind, and the water returns to normal. Similarly, when new information reaches a competitive market there is much turmoil as investors buy and sell securities in response to the news, causing prices to change. Once prices adjust, all that is left of the information is the worthless bone. No amount of gnawing on the bone will yield any more meat, and no further study of old information will yield any more valuable intelligence."
Robert C. Higgins, Analysis for Financial Management (May 2009 edition)

1.Appropriate benchmarks refer to comparable securities of similar characteristics. In other words, its important to compare apples to apples and oranges to oranges. For instance, small stock fund performance is best compared to an index of small stocks and growth stock fund performance is best compared to a growth stock index.

2. Value stocks are generally defined as stocks with a high ratio of book value/market while growth stocks have low book value to market ratios. Investment Gurus by Peter J. Tanous includes thorough discussions of these topics (see interviews with Eugene Fama and Rex Sinquefield).

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