Efficient Market Hypothesis (EMH)

By Pinyo, on April 7, 2008

In January, I wrote a review of The Only Guide To A Winning Investment Strategy You’ll Ever Need by Larry Swedroe. In his book, Larry dedicated a major portion of the book to the discussion of the Efficient Market Hypothesis (EMH), specifically to explain why investing in passively managed funds is a winning investment strategy.

What Is Efficient Market Hypothesis?

The Efficient Market Hypothesis asserts that the current market prices on traded assets, e.g., stocks, bonds, or properties, already reflect the total knowledge and expectation of all investors. It is unlikely that any one investor could use the information available to consistently produce above-market returns.

Larry also introduces two other efficiencies in his book — i.e., cost and risk:

Cost Efficient – The market is “cost efficient if the investor’s cost to enter into a market transaction is relative low… The more cost inefficient the market (the greater the spread between the bid and offer), however, the greater are both the cost of trading and the barriers active managers must overcome in order to beat their benchmarks.”
Risk Efficient – The market is risk efficient if “investments that entail greater risk provide investors with greater expected returns as compensation for the greater risk assumed.” For instance, stock has higher expected return than government treasury due to risks associated with investing in the stock market.

Why Does The Efficient Market Hypothesis Matters?

Efficient market hypothesis is important to understand because it explains why passively managed funds outperforms actively managed funds.

1. The costs of research and management

The main premise of active management is that superior performance can be achieved through research; specifically, by identifying mispriced investments and taking advantage of them. However, the cost of research and management is the first barrier that actively manage funds must overcome to beat their passively managed counterparts.

In other word, one reason why passively managed funds are superior to actively managed funds is their low costs (i.e., expense ratios, management fees, etc.) I demonstrated this concept, where a difference of 0.5% in expense ratio could result in a portfolio that underperform by nearly 15% over the course of 30 years.

2. The costs of trading

The second barrier that actively managed funds must overcome to beat passively managed funds is the costs of trading. The costs of trading include selling costs, buying costs, and the bid-offer spread.

It’s interesting thing to note when information efficiency is lower — i.e., lightly traded stocks, emerging markets, etc. — the cost inefficiency takes over and wipe out any advantage of active management. For instance, information dissemination is slower for smaller stocks, but that advantage is wiped out by the higher bid-offer spread.

3. Taxes

Lastly, investors who hold actively managed funds in their taxable account have to contend with taxes. Specifically, there are two that these investors have to deal with:

Depending on the level of turnover, or how much trading was done, the fund could accrue significant amount of capital gains. These capital gains result in capital gains distribution at the end of the year which is subject tax.
Likewise, dividends result in distribution which is subject to tax.

Summary

In short, actively managed funds are unlikely to outperform passively managed funds due to the costs associated with actively managed funds. Moreover, it’s unlikely that active managers can consistently identify and take advantage of mispriced stocks to outperform the indices due to the Efficient Market Hypothesis.

For more information about Efficient Market Hypothesis, and passive investing as a winning investment strategy, I recommend The Only Guide to a Winning Investment Strategy You’ll Ever Need by Larry Swedroe

What others are saying about Efficient Market Hypothesis:

Creative uses of efficient markets at Freakonomics
Weekly Market Commentary, March 4th 2008 at Stock Trading To Go
How Do Finance Professors Invest? at Consumerism Commentary
Is the Market Efficient? (Part 1 of 3) at Million Dollar Journey
The efficient market hypothesis at Early Retirement Extreme

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Pinyo is the brain behind Moolanomy personal finance blog and a few other web sites. If you like this article, please subscribe for free daily email updates.

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17 Comments

Cameron
April 7, 2008, 6:36

great summary of EMH. This was such a mind-blowing concept when I first learned it in school. It’s controversial because it essentially calls out an entire industry of forecasters and stock-pickers…the so-called “experts” and says that their job is meaningless….not something that is popular on Wall Street. “Random Walk Down Wall Street,” explains the same concept and is still the scorn of many streeters.

-Cameron
Vered@MomGrind
April 7, 2008, 9:05

I completely agree. I do own actively managed mutual funds, in addition to index-based funds and ETFs, but I am a buy-and-hold-type investor and I always look for low-cost, tax-efficient funds. Even within actively managed funds, there are huge differences in cost. I like many of the T. Rowe Price offerings for this reason.
Million Dollar Journey
April 7, 2008, 9:45

Thanks for the reference Pinyo.
Adfecto
April 7, 2008, 9:58

Great overview of EMH. It is an important idea that can save investors from the sharks on Wall Street. Bring on the index funds!
Four Pillars
April 7, 2008, 20:58

Good post.

MDJ’s series on the topic was quite excellent.

Interestingly enough another blogger I read posted on the exact same topic today….
http://michaeljamesmoney.blogs.....heory.html

Needless to say I’m a pretty big believer in the emh.

Mike
TroubleMaker - I Like to Argue
April 7, 2008, 21:22

Look at a 10 year chart of the following funds – then tell me indexing is better!
vfinx,vtsmx (look pretty much the same don’t they?) vbinx – for your index funds.
dodbx,gatex, prpfx, lcorx – all active funds.

Which ones have more consistent returns? Which ones did a better job of preserving capital in the last bear market? Is it better to save 0.5% in management fees to lose 1/2 your money? That’s a rough ride – a ride which most people will bail out of and then miss the ride back up.

If markets were really efficient then all 250,000 CFA’s and fund managers would come to the same conclusions about the same economic data, and there would be no mutual fund industry. If markets were efficient there would be no Tech Bubble, no Housing Bubble, no Asian Contagian, no 1987 Crash, etc. etc. etc.

Now, don’t hear me saying you should try to time the market and all that crap, cuz i aint.

I don’t like Rydex Funds either, but they did a study of the efficient frontier from 1960 to present, then broke it down into what the efficient frontier for each decade was. The results? Investigate it for yourself. Bottom line is that markets change, and the efficient mix of investments does too. They also looked at the cycles of long-term (secular) bull and bear markets. In the bull markets any strategy worked, and indexing shined. In secular bear markets indexing just means you’ll have no growth in your portfolio for 15-20 years or however long the bear market lasts.

In reality, you will abandon your “plan” long before then and go off haphazardly to something else and become a statistic. The real world result of that is that you will not reach your retirement goals, or if you are in retirement, you will run out of money. I guess indexing is better than no strategy at all – if you have 70 years or an infinite life span like the trusts and foundations and pension plans that can stick with a fixed strategy for that long. But individual investors don’t have the same time horizons as institutions, nor the same ability to ride out a prolonged downturn. Oooops wait! Neither do they. Many of them are pawning of their losses on the taxpayers. The smart ones use a core and explore strategy where they may use indexes for their core exposure, but then they use professionals to exploit the cyclical inefficiencies of the market. And the ones who can’t teach – those who can DO.
TroubleMaker - I Like to Argue
April 7, 2008, 21:27

Oh, and somebody answer me this…… Why do Vanguard’s actively managed funds beat their index funds? Hmmm? C’mon now – you didn’t know that? Shame on you.

When everybody is doing it, whatever IT is, then it’s best to get out of it. The smart money NEVER invests with the herd. They get greedy when everyone else panics and they sell when everyone else is getting greedy.

Ever see a cattle drive before? Where are all those cows going? Yeah, that’s right, to the slaughterhouse.

Mooooo!
TroubleMaker - I Like to Argue
April 7, 2008, 21:34

Oh, and hey Cameron, you better check out Jeremy Siegel again. He’s got a “newer” idea.
TroubleMaker - I Like to Argue
April 7, 2008, 21:44

Finally, for now at least, don’t mistake me for a Wall St sympathizer. I think they’re all crooks. They’re the ones who began the buy-and-hold scam. “Buy our funds and hold them” so they can screw you.

Everyone here needs to get a subscription to Hulbert and spend some serious time evaluating several, if not dozens, of the top letters he tracks to find a strategy that rings with your personality and then stick to it. Be prepared to spend time and money investigating. There are some gems there. I won’t tell you which ones, though, because I’ve spent years figuring out what works and what doesn’t. You won’t appreciate it if you don’t put your own sweat into it. Please do NOT invest until you’ve examined the claims, methodologies, and performance records of at least a dozen of these letters. Here’s my one clue: confine yourself to the best risk-adjusted returns category.

My last piece of advice – invest more conservatively than your “risk tolerance” indicates you should. Everyone is a risk taker when they are making money. Everyone is insanely risk averse when they are losing it. Pain is greater than gain.

And so you don’t think I’m just blustering I’ll have you know I came through the bear market only down 4%, and have made a truckload of money since then. My compound rate of return for the last 8 years, including the savages of the bear market, is about 12% per year. In other words, I’ve more than doubled my money since the beginning of 2000. Have you??? (PS – I could care less whether you believe me or not.)
Make Friends, Earn Money
April 8, 2008, 2:13

I like Larry’s material I think that he makes a lot of sense for those of us who are releatively new to the investment game. Of course he is out to make a name for himself and plenty of other money too, but of the various authors I’ve read on the sbject of investment Larry’s is definately up there.
Pinyo
April 8, 2008, 8:11

@TroubleMaker — Welcome to Moolanomy and thank you for your comment.

Nice list of funds, but how do you explain the other two third that failed to live up to their respective indices? Please note that I am not arguing that indexing is the best for everybody, but for the general public with limited investing experience, I’d say it’s pretty good strategy.

“If markets were really efficient then all 250,000 CFA’s and fund managers would come to the same conclusions about the same economic data, and there would be no mutual fund industry.”

Even if all CFA and fund managers know that EMH is true, they wouldn’t admit it would they? That’s their livelihood. Why would anyone admit that their jobs add very little value.

“If markets were efficient there would be no Tech Bubble, no Housing Bubble, no Asian Contagian, no 1987 Crash, etc. etc. etc.”

That’s not what efficient market is about, is it? EMH is about the speed at which the market incorporate new data. But I do agree that EMH doesn’t do a good job of explaining certain emotional reactions (i.e., crashes).

In secular bear markets indexing just means you’ll have no growth in your portfolio for 15-20 years or however long the bear market lasts.

That assumes I am putting all my money in one basket. That’s why we have diversification, international investment, low (or negative) correlation investments,

“Why do Vanguard’s actively managed funds beat their index funds? Hmmm? C’mon now – you didn’t know that?”

Someone bound to beat the average right? But what’s the cost of beating that average, or better yet, how could average investors identify winners among thousands of losers?

If I have 25% chance of beating the average, and 75% chance of underperforming the average, I choose the average — thank you.

“invest more conservatively than your “risk tolerance” indicates you should. Everyone is a risk taker when they are making money. Everyone is insanely risk averse when they are losing it. Pain is greater than gain.”

Great advice
GL
April 9, 2008, 0:50

“It is unlikely that any one investor could use the information available to consistently produce above-market returns.”

Two words: Warren Buffett.
Pinyo
April 9, 2008, 4:54

@GL — I think you are just kidding from the winking face.

It’s a problem when average investors think they can be Warren Buffett. Beside, he’s not only an investor, he also lead and manage companies that he “invested” in.
GL
April 9, 2008, 12:05

@ Pinyo – sometimes a winking face is just a winking face.

My point here is that Buffett – the world’s greatest investor – did not have any secret insider knowledge. Although he’s a genius when it comes to numbers, he got all of his information from public sources: annual stockholder letters, press releases, etc. While it is true that he used to “lead and manage” some of his companies, it is not his general policy. For example, he does not manage the Coca Cola company – or GEICO – or most of his other companies. His main strategy is to find a good deal on a great company, pick an honest, hard-working manager, sit back and relax.

Also, I don’t think many people can be the next Warren Buffett – my main point is that this man outlived lots of economic theories and fads (like the “go-go” funds of the sixties, for example), and came out a winner by buying good stock cheap and holding on to it. And since ours is a free economy, I believe the best way to invest is to buy a share of Berkshire-Hathaway and let the world’s best investor manage your money.
james
April 9, 2008, 13:12

The Efficient Market Hypothesis was ripped from General Equilibrium Theory in Economics and applied to financial markets by jealous academics who couldn’t make a profit it in the real world.

So many assumptions in the original EMH are bounded by axioms that are never present in real situations.

For example, people are not always rational. We do stupid things. Emotions and emotional contagion do not coexist with rationality. Irrational behavior can dominate markets. If people were completely rational they would be somewhat predictable, at least on the aggregate level, and then you could profit and you would have a paradox for the EMH.

Another example, markets are not always in equilibrium. In fact, markets are rarely in equilibrium. In economics, so many variables in its models are held constant and are essentially frozen in time. The term Ceteris paribus applies to all economic models and it fails to take into account second, third and fourth order effects in the real economy. In reality markets are dynamic entities and the plethora of side effects are magnificent. Being able to see these effects allows for profits.

Also, EMH (in its stronger forms) assumes that prices reflect all available information and thus you cannot trade on this information. Well, if you had an extremely well dispersed set of information this would make sense, and some would argue that the modern world provides such a set. I argue that its not. So many companies and organizations hold monopolies on this information (institutional investors, hedge funds, i-banks, obviously insider traders but there are laws against that, etc). This grants them the ability to generate abnormal economic profits over the lay-investor.

The obtuse conclusion of the EMH that you cannot profit from information in the market is inconsistent with Ricardian Comparative Advantage. If you know about the principle of Time Value of Money you already present yourself as one who holds a comparative advantage in this market. You are instantly better equipped to analyze equities over anyone (I would say 99% of US pop.) who doesn’t know this principle.

If you apply the EMH to other markets besides financial markets, corporations and entrepreneurs have no incentive to enter the market. The EMH assumes a perfectly competitive market and this is perhaps the most ridiculous idea in economics. A perfectly competitive market is one where no one makes a profit. Wait a minute, a market where no one makes a profit? Are you joking me? Why does the market exist then? Isn’t this counter intuitive to economics?

Lastly, if you do subscribe to this ridiculous cult, than why can’t you see that passive investing and active investing mutual funds are both contrary to EMH. If you really believe in EMH you would put all your money in Indexes.

Like I said before, Modern Finance is a bunch of Voodoo made up by economists with mathematics/physics envy who try to place broad theories on the economy. They differ from these pure sciences in that when evidence is found that proves a theory wrong, the theory is thrown out. With the EMH, this is apparently not the case.

It is too bad that the EMH and modern portfolio theory is abused by finance professional, like brokers and financial advisers, to cheat money out of hard working Americans who lack financial acumen.
Pinyo
April 10, 2008, 8:00

@GL — “I believe the best way to invest is to buy a share of Berkshire-Hathaway and let the worldâ€™s best investor manage your money.”

I like your style and I do own some BRK-B (not enough I have to say). I wonder what’d happen when he retires.

@James — Thank you for your comment. I love to hear other perspective, especially ones that are different from mine. I can tell you are very knowledgeable about this subject and I appreciate your thought on this.
GL
April 10, 2008, 9:00

@Pinyo – when Buffett dies, the price will inevitably go down, but it’ll rebound eventually, because the intrinsic value of the company will not change. He’ll be turning 78 this year and he’s been talking of retiring. The succession plan is already in place, and there are four candidates who share his work ethic and investing philosophy, so I’d say we’ll be fine.

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