Eugene Fama’s Efficient Market Hypothesis

How in the world can investors consistently return portfolios that beat the S&P 500 year after year? Is it even possible?

Contrary to the few men in history that have beat the S&P (yes, Warren Buffett and Berkshire Hathaway have absorbed bigger losses than the S&P), Eugene Fama from the University of Chicago developed the efficient market hypothesis back in 1969 stating that markets are “informationally efficient”. How so? In the hypothetical situation that insider trading doesn’t exist, information will reach each investor at the same time, thus giving no one the upper hand in making the most coherent investment decisions. As a byproduct of this market behavior, investors will not be able to return profits (or losses) that exceed the market’s average returns. Again, this theory lies on the underlying fact that the market is (1) running on a risk-adjusted basis and (2) information is received to all parties at the same exact time.

So why don’t markets function like this? Keep in mind there are several fallacies today that explain why the market can never behave like this.

An installed principle in Fama’s hypothesis is that traders may overcompensate the information they receive and make irrational decisions. As theoretical as the hypothesis is, the theory is further construed with greater reliance on the psychology of the human mind, stating that factors like overconfidence and false grips on reality result in inefficiencies of traders as a whole entity. But, in the grand scheme of things, the market is always correct. Assuming that all people’s behaviors follow a normal distribution pattern (little to no investors steer away from the majority and make their own decisions against the power of the information provided), the three stipulations to the market state why the investing world runs the way it does. Aspects of behavioral finance and cognition biases help detail why there are always winners in investing, and why there are always losers in investing.

Weak-form efficiency: Future prices cannot be determined by past prices or past behavior of an investment. The only cure can come from fundamental analysis, which includes viewing the business models, financial statements, and economic moats of the entity being examined. The underlying theme stresses the importance of qualitative analysis as any hopes of (potentially) beating the market consistently. Contrary to quantitative and technical analysis (examining graphs), prices will randomly fluctuate in the absence of “fundamental information”. However, inconsistencies exist in this theory that have been able to model and closely emulate the non-random walk, or movement, of prices amongst investments. Research and the models done to disprove the weak-form efficiency can be found through scholarly research and a quick Google search.

Semi-strong-form efficiency: Markets tend to react with super-efficiency, adjusting prices to fundamental news instantaneously. Then, for example, why do stock prices after-hours move in the event of earnings reports made earlier during the trading day? Fama blames bias and irrational behavior done by investors to undercompensate or overcompensate the prices and actual valuation of the pricing of the stock. Inefficiencies, thus, can be capitalized by “smart” individuals that can make the correct investment decision until prices reach equilibrium, or where it should rightfully stand as its price. Inconsistencies like these create winner and losers in the world of investing.

Strong-form efficiency:  All information, public or private, is rightfully displayed to the public and all share prices are reflections of this information. In the real world, there is private information that is not leaked to the public, disproving this hypothesis. Insider trading is protected against the law, making the access to all information essentially heterogeneous. The strong-form efficiency stipulation guarantees that this cannot exist in the real world, but goes to prove that some money managers will make normal returns and some will outperform the market.

All in all, why learn this hypothesis? Eugene Fama’s thesis represents the core of behavioral economics that tracks the psychology and behavior of people and the markets we live in. The knowledge to know why our market runs as efficiently as it does can help economists compare behavior and the effects of macro- and micro-decisions to markets and their results. And that is the reason we study economics into the grand scheme of investing.

Comments

  1. Mahesh:

    Impressive hypothesis!

    Reply

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