Is the Market Efficient?

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This article is intended for the educated layman. It was written as part of a continuing series of articles on a variety of investment topics.  To view all the articles in this series, click on “More by the same author” in the left margin.

And, spite of pride, in erring reason’s spite,
One truth is clear, Whatever is, is right.

After Marxism, no economic theory today may be as derided and despised as the hypothesis of market efficiency.  Many have long decried it for denying the successes and personal autonomy of investors, and now it is being fingered as the ideology responsible for the recent financial crisis. Yet the hypothesis of market efficiency is much better grounded than Marxism (its opposite in principle) in clear analytical argument and evidence, and it even accords well with common sense, once one grasps it.  But the idea is often misunderstood, sometimes willfully.

So what does “market efficiency” mean? Many of its detractors don’t know.

The definition of market efficiency

There are several closely overlapping meanings of “efficient” in the context of financial markets. One is that the prices of investments reflect all information relevant to their valuation.  Another is that changes in prices reflect changes in relevant information very quickly. This is called “informational efficiency.” And yet another is that prices reflect all relevant information correctly.  This last meaning has the greatest implications for society and is the most problematic. It drags us from the purity of finance into the mud of politics and social theory.

Whether any of these meanings, especially the first, describes the actual behavior of market prices has enormous practical implications for how we should go about investing.

The father of the hypothesis of market efficiency, Eugene Fama, of the Booth School of Business at the University of Chicago, developed the hypothesis and conducted the initial research that confirmed it in the 1960s.  Ever since, the efficient markets hypothesis has been closely identified with the Chicago school of economic thought.1

The common sense that underlies the hypothesis is that, because numerous investment professionals and serious non-professionals, many of them intelligent and diligent, are constantly analyzing and judging each investment that is traded in public view, no single investment strategy or analytical style can prove more effective than the consensus for any length of time. As the investors trade, they move the prices of bonds, stocks, and so forth, toward what they collectively believe the investments to be worth.  Anyone who discovers an advantage is quickly found out by the others, and the advantage disappears as all the competitors pile on and change the prices. It doesn’t necessarily take many investment traders to create a highly competitive market.

Fama proposed that there might be three forms of the efficient markets hypothesis: the weak form, the semi-strong form, and the strong form.  All three forms are variants of the first of the three aforesaid meanings, that prices reflect all information relevant to valuation.

The weak form of market efficiency is that the prices of all investments reflect or incorporate – the economists’ word is impound – all information contained in past prices.  What this means in practice is that you can’t predict future returns from past prices, because the current price already reflects everything that can be learned from past prices.  This is plausible, because past prices are the most readily available information about an investment, and therefore the most readily used by all interested investors.  Charts of past prices are ubiquitous.  This form of efficiency implies, therefore, that technical analysis is useless. (As we saw in an earlier article, “technical analysis” is the name given to the esoteric practice of some analysts who do just this: try to predict future prices from patterns of past prices.)

The semi-strong form of market efficiency is that the prices of all investments impound all the publicly-available information in the world (but not private information). Semi-strong-form market efficiency subsumes weak-form market efficiency. Semi-strong-form market efficiency has a severe corollary: You can’t forecast returns with any published information, and all investment analysis is useless.  That means that not just technical analysis, but fundamental analysis of publicly-traded investments (the study of accounting data and economic conditions affecting investments) is a waste of the individual analyst’s time.

The strong form of market efficiency is that the prices of all investments impound all the information in the world, private as well as public. Strong-form efficiency subsumes semi-strong-form efficiency. This means that no one can predict the future return of an investment in any way whatsoever.

The strong form of market efficiency is clearly false, because it implies that no one could profit by cheating, and if you have learned little else from Wall Street shenanigans over the last decade or two – and matters were, if anything, worse in earlier times – you know that insiders can guarantee themselves pots of money at the expense of others, sometimes even if they’re caught at it. So let’s forget about strong-form efficiency, and consider the other two forms of the hypothesis.

Consequences of the hypothesis

Because there is no objective, God-given value for any stock, bond, or other investment, we are unable to test the hypothesis of semi-strong-form market efficiency by comparing known prices to known values of investments and seeing whether they unambiguously match.  Investment values are fallible estimates made by each analyst or investor. Only prices are known with reasonable certainty. So tests of market efficiency rely on inference.  One implication of market efficiency is that there is no point to picking stocks, or any other kind of investment, because you (or the investment manager you might hire) cannot consistently identify the investments that will be the winners except through an extraordinary run of sheer good luck. As a professor of mine at Chicago snarkily said, analysts cannot identify the winners and the losers, or if they can, they can’t tell them apart. Therefore, if we can show that the past performance of investment analysts and managers doesn’t predict their future performance, we have evidence that conforms to the semi-strong-form market efficiency.

Semi-strong-form market efficiency (which, in the interest of brevity, I will henceforth call simply “market efficiency”) is a step – a big step – beyond a position at which we can arrive through mathematical reason.

In an earlier essay, I pointed out that very roughly half of all the people and institutions who are choosing investments must do worse than the market, because the return on the market is the average of all the returns of all the investments it contains, and more than half the investment analysts and managers can’t beat the average.2 But of the approximate half who do get results better than the total market’s, a large proportion must be simply lucky.  Stock-picking (or any other investment-picking) is not like a sports league, where rank is what it is, and corresponds roughly to the skill exhibited in the current season versus the other individual players or teams. The ball being pitched toward you in the investment markets, in contrast, wasn’t hurled by one of your fellow investment analysts in a regulated game; it was hurled by the entire world of nature and mankind, in an arena where many may not abide by what few rules do exist.  Accounting rules may be ignored or bent.  Important executives can die or be hired away without notice.  Oil rigs can burn and collapse.  Volcanoes can disrupt transportation.  So at least a large proportion of those investment managers who do better or worse than the market, over any span of time one might select, should ascribe their fortune, good or ill, to pure chance.3

The hypothesis of market efficiency goes beyond this argument to imply that nearly all of the remainder of investment analysts and managers, the ones who appear to be successful, are also merely lucky. (No one, not even Fama, goes so far as to deny that someone might have the skill to achieve returns that are superior to the market’s.)  Thus, regardless of the validity of the efficient markets hypothesis, it must always be the case that only a minority of investors can get better returns than the financial markets through their skill, and if the financial markets are efficient, then this minority is very, very tiny.

1 The best popular account of the efficient markets hypothesis is the recent book by Justin Fox, The Myth of the Rational Market: A History of Risk, Reward, and Delusion on Wall Street(HarperBusiness, 2009), which provides the historical context, replete with character sketches, of the development of the idea. The book itself is balanced and belies the loaded word “myth” in its title.

2 Ibid. There is a long footnote that qualifies this statement, pointing out, among other things, that half the dollars invested, rather half the investors, underperform, but it is still roughly true that about half the people responsible for investing cannot outperform the market. Those who don’t choose particular investments, but instead invest in market index funds, are right at the average, less the modest fees that they pay.

3 One instance of spectacular luck of either sort can, through the mathematics of compound returns, produce effects that persist in the average return over long spans of time. One might argue that the skilled analyst responds more appropriately to surprises than the less skilled; perhaps so, but I think we can agree that not everyone whose investment results are above average has skill.