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The Efficient Market Hypothesis

(This is an excerpt from my upcoming book on positional option trading.)

The traders’ concept of the Efficient Market Hypothesis (EMH) is, “making money is hard”. This isn’t wrong, but it is worth looking at the theory in more detail. Traders are trying to make money from the exceptions to the EMH, and the different types of inefficiencies should be understood, and hence traded, differently.

The EMH was contemporaneously developed from two distinct directions. Paul Samuelson (Samuelson, 1965) introduced the idea to the economics community under the umbrella of “rational expectations theory”. At the same time, Eugene Fama’s studies (Fama, 1965 a and b) of the statistics of security returns lead him to the theory of “the random walk”.

The idea can be stated in many ways, but a simple, general expression is:
A market is efficient with respect to some information if it is impossible to profitably trade based on that information. And the “profitable trades” are risk adjusted, after all costs.

So, depending on the information we are considering, there are many different Efficient Market Hypotheses, but three in particular have been extensively studied.

1.       The strong Efficient Market Hypothesis where the information is anything that is known by anyone.
2.       The semi-strong Efficient Market Hypothesis where the information is any publicly available information, such as past prices, earnings or analysts’ studies.
3.       The weak Efficient Market Hypothesis where the information is past prices.

The EMH is important as an organizing principle and a very good approximation to reality. But, it is important to note that no one has ever believed that any form of the EMH is strictly true. Traders are right. Making money is hard, but it isn’t impossible. The general idea of the theory and also the fact it isn’t perfect is agreed upon by most successful investors and economists.

“I think it is roughly right that the market is efficient, which makes it very hard to beat merely by being an intelligent investor. But I don’t think it’s totally efficient at all. And the difference between being totally efficient and somewhat efficient leaves an enormous opportunity for people like us to get these unusual records. It’s efficient enough, so it’s hard to have a great investment record. But it’s by no means impossible. “
-Charlie Munger

Even one of the inventors of the theory, Eugene Fama, qualified the idea of efficiency by using the word, “good” instead of “perfect”.

“In an efficient market, at any point in time, the actual price of a security will be a good estimate of its intrinsic value.”
-Eugene Fama.

There is something of a paradox in the concept of market efficiency. The more efficient a market is, the more random and unpredictable the returns will be. A perfectly efficient market will be completely unpredictable. But the way this comes about is through the trading of all market participants. Investors all try to profit from any informational advantage they have, and by doing this their information is incorporated into the prices. Grossman and Stiglitz (1980) use this idea to argue that perfectly efficient markets are impossible. If markets were efficient, traders wouldn’t make the effort to gather information, and so there would be nothing driving markets towards efficiency. So, an equilibrium will form where markets are mostly efficient, but it is still worth collecting and processing information.  Traders can make profits from their efforts. Not all traders will. A lot of traders will use meaningless or widely known information (This is a reason fundamental analysis consisting of reading The Wall Street journal, and technical analysis using well known indicators is likely to be useless.). Fischer Black (1986) called these people “noise traders”. They are the people who pay the good traders.

    There are other arguments against the EMH. The most persuasive of these are from the field of behavioral finance. It’s been shown that people are irrational in many ways. People who do irrational things should provide opportunities to those who don’t. As Kipling wrote, “If you can keep your head when all about you are losing theirs, … you will be a man my son.”

Let’s accept that the EMH is imperfect enough that it is possible to make money. The economists who study these deviations from perfection classify them into two classes: risk premia and inefficiencies. A risk premium is earned as compensation for taking a risk, and if the premium id mis-priced it will be profitable even after accepting the risk. An inefficiency is a trading opportunity caused by the market not noticing something. An example is when people don’t account for the embedded options in a product.

There is a joke (not a funny one) about an economist seeing a $100 bill on the ground. She walks past it. A friend asks: "Didn't you see the money there?" The economist replies: "I thought I saw something, but I must've imagined it. If there had been $100 on the ground, someone would've picked it up." The EMH is false, but the money could be there for two different reasons. Maybe it is on a busy road and no one wants to run into traffic. This is a risk premium. But maybe it is outside a bar where drunks tend to drop money as they leave. This is an inefficiency. There is also the possibility that the note was there purely by luck.

It is often impossible to know whether a given opportunity is a risk premium or an inefficiency, and a given opportunity will probably be partially both. But it is important to try to differentiate. A risk premium can be expected to persist: the counter-party is paying for insurance against a risk. They may improve their pricing of the insurance, but they will probably continue to pay something. In contrast, an inefficiency will last only until other people notice it. And failing to differentiate between a real opportunity and a chance event will only lead to losses.

Black, F.,1986, “Noise”, Journal of Finance, 529-543.

Fama, E, F., 1965a.  ” The Behavior of Stock-Market Prices”, The Journal of Business, 34-105

Fama, E, F., 1965b. “Random Walks in Security Prices.” Financial Analysts Journal, 55–59

Grossman, S.J. and J. Stiglitz, 1980, "On the Impossibility of Informationally Efficient Markets". American Economic Review, 393–408.

Samuelson, P., 1965. "Proof That Properly Anticipated Prices Fluctuate Randomly". Industrial Management Review.41–49.