By: Investor Solutions, Inc.

The Efficient Market Hypothesis has been one of the most fiercely debated topics in the world of modern finance, since it was first introduced nearly forty years ago by academic legend Eugene Fama (now a professor at University of Chicago). It is the catalyst that has fueled the ongoing “active” versus “passive” debate which pits the technical/fundamental analysts that rule Wall Street against the growing number of “indexers” around the globe. Given the magnitude of its impact in modern finance, it deserves some attention. Here’s a look at the fire that sparked an economic revolution.

The Efficient Market Hypothesis (EMH for short) suggests that investors cannot expect to consistently and reliably outperform the market on a risk adjusted basis over an extended period of time. The EMH argues that security prices adjust rapidly to new information and must reflect all known information concerning the firm. So, the current price must appropriately value the firm’s future growth and dividends and is therefore a true measure of the security’s worth.

Since security prices rapidly incorporate all public information, the day to day prices must follow a “random walk” over time (meaning stock prices are not predictable and patterns are merely accidental). Any attempt to try and predict such patterns or pricing movements is rendered ineffective and useless. Despite this, some individuals blessed with luck have managed to beat the market, but the costs (including taxes and trading costs) far outweigh the benefits of trying. For more on this read Frank Armstrong’s piece “An Easy Two Percent”.

There are two main methods that stock analysts use to try and predict future stock prices: technical analysis and fundamental analysis. Technical analysis uses past patterns of price and the volume of trading as the basis for predicting future prices. Fundamental analysis involves using market information to determine the intrinsic value of securities in order to identify undervalued (or overvalued) securities.

Forms of the Efficient Market Hypothesis

There are three distinct variations of the Efficient Market Hypothesis: the weak, semi strong and strong forms.

The weak form EMH assumes that all information about stock prices and price trends is already reflected in the current market price. It further stipulates that fundamental analysis may produce superior investment results, but that technical analysis (that studies past price behavior and other technical indicators of the market) will not produce superior investment results.

The semi strong form EMH states that all publicly available information is fully reflected in a security’s current market price. This public information includes not only past prices, but, also data reported in a company’s financial statements. It implies that no one should be able to outperform the market using information that “everybody else knows”. Therefore using a company’s financial statements are of no help in forecasting future price movements and securing high investment returns.

The strong form of the EMH implies that insider information is also quickly incorporated by market prices and, therefore, cannot be used to reap anomalous trading profits. It assumes that “inside information” does not stay inside for long, and that too many people know about the activities of the firm. All information (whether public or private) is fully reflected in a security’s current market price. Therefore, access to inside information does not give rise to superior investment performance.

Our recap of the EMH has suggested that no one can consistently and reliably outperform the market either with security selection or market timing. Of the three EMH forms, the most widely accepted is the semi-strong interpretation, whereby the use of privileged inside information mayresult in superior investment performance, but use of public, widely known information cannot be expected to consistently produce superior investment results. Therefore, neither technical nor fundamental stock analysis can have a positive impact an investor’s success, a concept that Wall Street will adamantly deny, especially when its livelihood depends on it.

If you believe in the EMH (and, of course, I do), then investors in search of the most optimal investment strategy will be better served to abandon the “beat the market” mentality and opt instead for a passive, globally diversified investment strategy comprised of index funds. And despite that fact that the EMH debate will never be settled, I trust that in the long run, passive investors will have the last laugh and having greatly benefited from the revolution that Fama sparked.