Although its name may believe you into thinking that this hypothesis is in fact "efficient", it is in fact not. It has actually caused quite some controversy that has plagued the finance and investment industry.
What Is This Controversy?
According to the EMH, markets are absolutely efficient. The theory states in a highly liquid market, stock prices are valued to reflect all the available information given at a certain time.
The assumption is that all market prices automatically re-adjust to whatever new information is being put out there. If a market always reflects its information accurately, no one will be able to have an advantage over the. This somewhat prevents alpha, excess return, since no positive risk adjusted returns are possible in an equal market.
This can also affect portfolio managers as instead of having their focus being on beating the prices of the stock market, they now have to find other ways to add value to their portfolio whether it be through taking on more risky investments or tax optimization.
The Three Doctrines
There are three doctrines of the EMH-the weak, the semi-strong, and the strong. As we move from the weakest to the strongest variation of the theory, we see that we gradually move from less information to the incorporation of all information.
The weak form suggests that the prices reflect all the information that is available at its given time such as its past price. It’s implication is that charts and technical trading will not lead itself to excess returns since past performance is irrelevant. Rather, fundamental analysis will lead to alpha. But even this may be inaccurate as fundamental analysis can be prone to human error despite the growing use of technology to calculate a stock’s true market value.
Similar to the weak form, semi-strong form indicates that the stock prices reflect all current information but with the addition of all public information. Since private information is being withheld from the public, the only way to receive alpha is through insider trading.
The strong form of the theory combines the weak and the semi-strong in that it incorporates all public and private information. Because technical trading cannot be used in the weak form and fundamental analysis cannot be used in the semi-strong form, alpha is unattainable in the strong tenet. This suggests that the market is perfectly efficient since making profit is next to impossible.
Is The EMH Realistic?
I don’t want to be the bearer of bad news, but it is highly unlikely.
This theory is criticized for multiple reasons such as the fact that it centers on the idea that investors are rational. Not all humans are the same and everyone processes information differently. It’s why some people believe that In-N-Out is better than Shake Shack and vice versa. If we all processed information the same, we would all think that Shake Shack is the superior joint.
Similarly, not all investors perceive the given information in the same way and they might have different goals to. Not everyone who walks into Shake Shack wants the same order as you. Some may want the cheese fries, others may want no fries. The same thing applies again. Someone who is looking for growth potential will arrive at a very different fair market value than someone who is looking for undervalued opportunities. So since investors value stocks differently based on their individual wants and needs, this leads to an inaccurate reflection of the price in an efficient market.
What Doesn't the EMH Consider?
The EMH also doesn't consider the idea that people need incentives. Since people have access to the same information and they process it the same way, only identical results can be achieved. Although it sounds great in theory that no one will be able to achieve greater results with the same amount of investments, why would people continue to invest if the co-worker they dislike is making the same amount of returns as they are?
Very important to finance: which is better? Shake Shack or In'n'Out? Let us know your thoughts below!