Efficient Market Hypothesis: Propaganda for Passive Investing?

Efficient market hypothesis (EMH) is an investment theory that states it is impossible to "beat the market" because stock market efficiency causes existing share prices to always incorporate and reflect all relevant information (Malkiel and Fama, 1970). According to the EMH, stocks always trade at their fair value on stock exchanges, making it impossible for investors to either purchase undervalued stocks or sell stocks for inflated prices. Thus, making it impossible to outperform the overall market through expert stock selection or market timing, and the only way an investor could possibly obtain higher returns is by purchasing riskier investments [1].

 Fool’s gold

Although, EMH appears sound in theory, it has been proven wrong on multiple counts in modern financial history. Initial signs of inefficiency coming from The Market Crash of October 1987, where a one-third drop in market prices took the financial players by storm. This was followed by The Internet Bubble of the late 1990’s wherein inflated market values assigned to Internet and related high-tech companies seemed inconsistent with rational valuation (Malkiel, 2003). The final test followed the ice-berg of The Financial Crisis of 2008. Before this, the theory had held strong for decades and formed a strong basis for financial markets and regulations [2] .

 Numerous finance laureates and experts have tried to explain the plausible reasons for the inefficiencies causing the EMH to falter, some of these are –

• Behavioural economists attribute the imperfections as a result of cognitive biases such as overconfidence, overreaction, representative bias, information bias, and various other predictable human errors in reasoning and information processing[3].
• Misperceiving the market price of securities by traders. Their misperceptions contribute to fluctuations in prices, and push prices to a discount below fundamental value because of the price uncertainty they introduce (Long et al., 2007)
• Certain patterns in stock prices, which the EMH fails to explain such as the non-dependency of stock returns today and returns tomorrow (Naseer and bin Tariq, 2015); these could be exploited through arbitrage techniques.

 According to Warren Buffet,

“Ships will sail around the world but the Flat Earth Society will flourish. There will continue to be wide discrepancies between price and value in the marketplace, and those who read their Graham & Dodd will continue to prosper” [4].

Popular by the name of The Superinvestors of Graham-and-Doddsville, the article challenges the idea that equity markets are efficient through a study of nine successful investment funds generating long-term returns above the market index. All these funds were managed by Benjamin Graham's alumni, pursuing different investment tactics but following the same "Graham-and-Doddsville" value investing strategy (Buffet, 1984).

Source: The Superinvestors of Graham and Doddsville

 Connecting the dots…

Basis the analysis above, intuitive arguments suggest proponents of EMH have been behaviourally biased and skewed in their preferences towards passive investing over the years and are therefore, staunch promoters of passive investing over active. But, then again, our conjecture might be far from the actual truth.

 References

 Buffet, W. (1984) ‘The-Superinvestors-of-Graham-and-Doddsville-by-Warren-Buffett.pdf’.

 Long, J. B. De et al. (2007) ‘Noise Trader Risk in Financial Markets Author ( s ): J . Bradford De Long , Andrei Shleifer , Lawrence H . Summers and Robert J . Waldmann Source : Journal of Political Economy , Vol . 98 , No . 4 ( Aug ., 1990 ), pp . 703-738 Published by : The Universit’, The Journal of Political Economy, 98(4), pp. 703–738.

 Malkiel, B. G. (2003) ‘The efficiente market hypothesis and its critics’, Journal of Economic Perspectives, 17(1), pp. 59–82. doi: 10.1257/089533003321164958.

 Malkiel, B. G. and Fama, E. F. (1970) ‘EFFICIENT CAPITAL MARKETS: A REVIEW OF THEORY AND EMPIRICAL WORK*’, Journal of Finance. Oxford, UK, 25(2), pp. 383–417. doi: 10.1111/j.1540-6261.1970.tb00518.x .

 Naseer, M. and bin Tariq, Y. (2015) ‘The Efficient Market Hypothesis: A Critical Review of the Literature’, IUP Journal of Financial Risk Management, 12(4), pp. 48–63.

 [1] Efficient Market Hypothesis (EMH) – Investopedia

[2] Norma Cohen (January 2012) – “‘Efficient markets hypothesis’ inefficient”, Financial Times

[3] May 2010 – “Whither Efficient Markets? Efficient Market Theory and Behavioural Finance” - The Finance Professionals’ Post (Publication of the New York Society of Security Analysts)

[4] Warren Buffet (May 1984) – “The Superinvestors of Graham-and-Doddsville” – Columbia Business School