Money Sundays: The Efficient Markets Hypothesis Explained in Simple Terms

Readers: I wrote this post years ago for a long-defunct website. I thought I’d republish it here at Casual Kitchen for those readers interested in investing and personal finance. Feel free to skip it!

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What are efficient markets?

Perhaps you've heard the joke about the economist walking down the street with one of his students. The student sees a $20 bill lying on the sidewalk. As he bends down to pick it up, he hears his professor laugh mockingly at him and saying, "If that were REALLY a twenty dollar bill, somebody would have picked it up already!"

The intellectually intimidated student stops himself mid-bend, laughs timidly, and leaves the $20 lying right there, stealing longing glances at it as they pass it by.

Well, saying markets are perfectly efficient is just like being that condescending economics professor. He just left a perfectly good $20 bill untouched on the ground, AND he convinced his student to leave it there too. All because he believed it couldn't actually be there.

The whole notion of efficient markets has become so contentiously debated that three separate forms of the theory have evolved:

1) Strong Form Efficient Markets Hypothesis
Basically, this version of the theory says that stock prices reflect all information and there's no way you can possibly "beat the market" (or as the academics would phrase it: earn excess returns).

This version of the theory is easy to understand, elegant.. and it's pretty much been proven false by the collective weight of the evidence. But it's a good starting point to help illustrate the other versions of the theory.

2) Semi Strong Form Efficient Markets Hypothesis
This version of the theory says that stock prices react so quickly to new information (say, if a company gets a buyout offer, or if a company prints terrible quarterly results), that there's no way you can make money by trading on that information once it's out. Obviously "insiders" know about such information in advance (and are prohibited from trading on that knowledge by SEC rules), but normal investors like us who see the good or bad news will not be able to buy or sell the stock before the price adjusts.

There are problems with this version of the theory too, namely that stocks tend to overreact to news in the short term and under-react to news in the long term. Thus you can often make money by playing the other side of the trade: for example, by selling a stock after it spikes on a great quarter print, or buying a stock after it falls due to a disappointing news event.

3) Weak Form Efficient Markets Hypothesis
This version of the theory argues that you can't make money with any strategies using historical share prices or other financial information. This says basically that technical investing (using charts to make stock market buy and sell decisions), will never make you money. Furthermore, using historical financials will likewise not be useful, because that information will have already been baked into the current stock price. The theory still allows for investors to do what's called "fundamental analysis" to identify stocks that are undervalued and overvalued.

This is probably the most palatable version of the theory to most EMH adherents. Even so, there are instances where it falls on its face too. For example there are instances in recent history where company financials contained serious red flags that were notable and visible to anybody who could read financial statements. Enron comes to mind as one of the most prominent examples, as the company consistently and inexplicably ran years of negative cash flows despite showing years of accounting profits. This is one of the oldest red flags in the book.

I'll leave you with a few final thoughts, one from me and two from a couple of investors that are a bit more well-known and well-regarded.

First, it's always a bit disconcerting when a theory of markets experiences a schism--a three-way schism no less! It makes you wonder whether it, or any of the offshoots, can really stand on their own.

Second, Warren Buffet, an investor with a lot more credibility than I'll ever have, had this to say of professors who teach Efficient Market Theory: "Observing correctly that the market was frequently efficient, they went on to conclude incorrectly that it was always efficient."

And of course it was John Maynard Keynes, renowned 20th century economist and investor, famously said, "Markets can remain irrational a lot longer than you and I can stay solvent."

So the next time you're walking with a condescending economics professor who believes in Strong Form EMH and you see a $20 bill lying on the sidewalk, bend down and pick it up! As you're putting it into your wallet, say you prefer the Weak Form.


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