Investing Basics: What Is The Efficient Market Hypothesis, and What Are Its Shortcomings?

Over the past 50 years, efficient market hypothesis (EMH) has been the subject of rigorous academic research and intense debate. It has preceded finance and economics as the fundamental theory explaining movements in asset prices. The accepted view is that markets operate efficiently and stock prices instantly reflect all available information. Since all participants are privy to the same information, price fluctuations are unpredictable and respond immediately to genuinely new information. As a result, efficient markets do not allow investors to earn above average returns without accepting additional risks. Yet, as we all know or have experienced ourselves, markets do not always act this way or exhibit rationality. In fact, a fundamental shortcoming of EMH is its inability to explain excess volatility. While efficient market theory remains prominent in financial economics, proponents of behavioral finance believe numerous biases, including irrational and rational behavior, drive investor’s decisions.

Efficient Markets

Fundamental to modern portfolio theory, efficient markets are the basis that underpins financial decision making. In the early 1960s, Nobel Prize winning economist Eugene Fama put forth the theory of efficient markets, which continues to garner acceptance throughout the field of finance. Fundamental to Fama’s theory are inherently efficient markets, rational expectations and security prices reflecting all available information. The logic behind this is characterized by a random walk, where all subsequent price changes reflect a random departure from previous prices. Since share prices instantly reflect all the available information, then tomorrow’s prices are independent of today’s prices and will only reflect tomorrow’s news. In this case, news and price changes are unpredictable. Therefore, both a novice and expert investor, holding a diversified portfolio, will obtain comparable returns regardless of their varying levels of expertise.

As we know, the distribution of news is channeled through various sources and according to Fama, this represents three different forms of market efficiency; strong form, semi-strong form, and weak form.

Strong form efficiency is where all information, public, personal and confidential, is reflected in share prices. Therefore investors are unable to achieve a competitive advantage and deters insider trading. This degree of market efficiency implies that above average return cannot be achieved regardless of an investor’s access to information.

To a lesser degree, semi-strong efficiency proposes that share prices are a reflection of publicly available information. Since market prices already reflect public information, investors are unable to gain abnormal returns.

In its last degree, weak form efficiency claims all previous stock prices are a reflection of today’s price. Therefore, technical analysis is not a practical tool to predict future price movements.

Efficient Market’s Shortcomings

While efficient market theory resonates throughout financial research, it has often fallen short in its application throughout history. In the wake of the 2008 Financial Crisis, many of our traditional financial theories have been challenged for their lack of practical perspective on the markets. If all the assumptions about efficient markets had held, then the housing bubble and subsequent crash would not have occurred.

Yet, efficiency failed to explain market anomalies, including speculative bubbles and excess volatility. As the housing bubble reached its peak and investors continued to pour funds into subprime mortgages, irrational behavior began to precede the markets. Contrary to rational expectations, investors acted irrationally in favor of potential arbitrage opportunities. Yet an efficient market would have automatically adjusted asset prices to rational levels.

Besides its failure to address financial downturns, the theory itself has often been contested. In theory, each individual is able to access and analyze information at the same pace. However, with the growing number of information channels, including social media and the internet, even the most involved investors are unable to monitor every piece of information. With that being said, investment decisions tend to be influenced more so by emotions rather than rationality.

A Behavioral Approach

Like any new study, behavioral finance began from the anomalies that the prevailing wisdom, efficient markets, could not explain. As a budding field, behavioral finance seeks to incorporate cognitive psychology with conventional finance in order to provide an explanation for irrational investment decisions. At its core, behavioral finance is based on the notion that investors are subject to behavioral biases which influence less than rational decisions. Often times, behavioral based biases come from cognitive psychology and have been applied to financial markets. Some popular biases include; overconfidence, anchoring, hindsight bias, and gambler’s fallacy to name a few:

  • Overconfidence: While this trait can applied outside of finance, in terms of investing, overconfidence is an investor’s intuition to overestimate their ability to process information and pick winning stocks.
  • Anchoring: Fundamentally, anchoring draws on our tendency to attach our thoughts to a reference point, often times our initial decision, and refuse to waver regardless of access to new information.
  • Hindsight Bias: Drawing its roots from basic psychology, hindsight bias is the belief that past events were predictable and should have been acted on at the time. In many cases, this is a form of rationalizing previous errors and can lead to overconfidence.
  • Gambler’s Fallacy: The concept of gambler’s fallacy is connected to flipping a coin. When you flip a coin, the probability of it turning up heads or tails is always 50%, regardless of the previous flip. Yet, even in investing, individuals will fail to recognize that past events are independent of the future.

While these are some of the most frequently exhibited phenomena, many other biases present themselves in our decision making. Taking investors bias’s into account, stock mispricing can occur in predictable fashions, giving credence to an active manager’s ability to identify sources of mispricing.

With this in mind, markets clearly do not price assets as rationally as an efficient market would claim. Identifying your biases and working to recognize mistakes, understand other people’s decisions, evaluate market trends, and plan for the future can have lasting effects on your investment choices.

Therefore, constructing a portfolio with a behavioral approach should incorporate multiple layers with each layer representing a well-defined goal. The base layer, for example, should intend to hold low risk assets as a means to mitigate risk and losses, while a higher level would attempt to maximize returns.

Many concepts of behavioral finance tend to contradict the foundations of efficient markets. With that being said efficiency should not be discounted altogether. Your future research and decisions should approach the market from an eclectic standpoint. Understanding the strengths and weaknesses of multiple theories may not make you the next Warren Buffet, but can significantly help you comprehend new information and make more informed investment decisions.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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