When considering asset strategies such as Asset Allocation theory, there are other, highly controversial and disputed theories in existence. In fact, these theories have been developing since the 1860s, but have gathered pace since the middle of the 20th century and are constantly being re-examined. One of these is Efficient Market Hypothesis, which has its origins in French economic theorization and random walk mathematics.
Efficient Market Hypothesis, or EMH for short, is a pessimistic stock market strategy and theory based on the principle that no one can beat the market long term. This belief is rooted in the idea that the masses know best when it comes to overall stock market values. Perhaps this is a little different from the ideas of populist politicians or subverting oneself to the baying mob, but in financial terms it means trusting the market to offer fair value for its stocks, so that no stock is overvalued or undervalued, but that all values represent exactly what that stock is worth at that moment. As a result, the belief holds that it is impossible to fairly predict trends.
Development
EMH was one of the first theories developed on stock market strategy. It was an attempt by Jules Regnault to help define a stock market science in 1963 and onwards. His baton was taken up by compatriot Louis Bachelier with his PhD thesis in 1900. The idea was based on a mathematical formulation known as Random Walk Theory. This was largely ignored in the Anglophone world until the 1930s when Alfred Cowles added to the ideas and a number of small studies by stating that the professional investor could never outperform the markets on a long term basis. The idea took off in the 1950s and 60s with the work of Eugene Fama and Paul Samuelson. EMH held sway until the 1990s when ideas based on behavioral finance overtook it.
The Theory
The theory is based on individual agents or investors pitted against the market as a whole. This theory holds for all types of value market from stocks to bonds and also to real estate. Each investor should base their expectations of asset value based upon the market as a whole because the market is efficient and not lie. If a stock has a low value then it must be a poor stock to invest in. The opposite is naturally true of high value stocks. As a result, the value of investments is put on the market as a whole and specific investments can be random so long as they are evenly distributed. In the end, the EMH is broken down into weak, semi-strong and strong forms of efficiency.
Weak efficiency is based on the idea that past prices of stocks or properties are no guide for future prices. As a result, this information will not aid the creation of excess returns, though the theory does allow for some use to be made from fundamental analysis. It is based on the idea that price fluctuations are in essence, random.
Semi-Strong efficiency reflects the information available and the value of stocks as a whole will vary according to any new information presented. This assumes that stocks and properties are able to change value quickly based on a public opinion of the new information made available. In terms of property prices, for example, a house worth $250,000 according to set A of information may devalue if set B of information reveals a sewage plant will soon be built next to it. Any reaction to news that is too high or low reflects innate bias in the investor’s opinions, through overreaction or under-reaction to known and/or unknown information.
Strong efficiency is based on the idea that these values reflect both known and unknown information. As a result of this, it is impossible to earn excess returns. Taking the example from above and flipping it, if the sewage plant is set to close and be converted into parkland, then the price of the property would rise. Under semi-strong efficiency the price would be $250,000 and would then rise with the new information, but under strong efficiency the unknown information is already factored into the value and therefore, when it becomes public, the property’s value would not rise and there would be no profit in the investment.
Criticism
While the career of Warren Buffet could act as a one-man critique of Efficient Market Hypothesis, it is worth looking in more depth than that about the failings of a once dominant market theory. It disregards gut instinct and assumes that unnatural fluctuations are based on human biases such as overreaction and under-reaction, but possibly insider information. It also assumes that all information is known and that values do not change without new information. This new information cannot be predicted until it happens, then it is a case of reactionary investment.
The flaws in the system are legion. Behavioral Finance began to look into how human behavior, informational bias, overconfidence and so on can be built into predicting stock and asset performances, and also how to make a profit strategy from it. This was based on stats that showed that between 1966 and 1996 50 percent of fun managers managed to outperform the S&P 500. This demonstrated that the chances of doing so were greater than allowed by EMH, which would have the percentage closer to zero.
It also ignored bubble economies and market crashes. A bubble economy occurs when wild overconfidence leads to massive investments in certain areas. These have include Japan, e-commerce businesses (perhaps twice?) and property. When investors realize their mistakes, the bubble can burst and billions of dollars are wiped out. EMH would have it that all properties, for example, are worth their fair value, so when buying or leasing a property you are paying the amount the property is worth because the market says it is worth that much.
A market crash often happens when a bubble bursts or something goes spectacularly wrong and investors get the jitters. In 1987, on Black Monday, the Dow Jones Industrial Average lost 20 percent of its value in one day. In 2007, business went bankrupt, houses were repossessed and banks went to the wall as a massive property and investment bubble burst.
Jeremy Grantham blamed EMH for this as its belief in fair market value led to investors and fund managers becoming too confident in the value of the market they were investing in. While this was rejected by Fama, who blamed the recession for the crippled markets rather than vice versa, it seems that EMH is a stock market strategy with waning influence. Then again, in the 2000s they thought the mistakes of the 1930s would never be repeated.
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