[Theory] Understanding the Efficient Market Hypothesis (EMH): Market Efficiency and the Debate over Excess Returns
1. What is the Efficient Market Hypothesis (EMH)?
Anyone investing has probably thought this at least once: "If I stay up all night and find a great financial statement that others don't know about, or discover an awesome chart pattern, couldn't I make a lot of money in the stock market?"
The theory that handed down the coldest and most brutal death sentence to this sweet illusion is the Efficient Market Hypothesis (EMH), published by Eugene Fama in 1970.
The central claim of the Efficient Market Hypothesis is that available information is incorporated into prices quickly enough that repeatedly earning risk-adjusted excess returns from that information is difficult. This does not mean prices are always correct or that no investor can outperform in any period. Findings depend on the form of efficiency being tested, trading costs, the information set, and the method used to adjust for risk.
2. Three Forms of the Efficient Market Hypothesis
Eugene Fama classified the efficient market into three stages based on the 'depth of information' reflected in the market.
① Weak Form Efficiency
- Definition: The hypothesis that 'historical information', such as past price movements and trading volume, is already 100% reflected in the current stock price.
- Conclusion: 'Technical analysis' (chartists), which tries to predict the future by drawing lines on charts and analyzing past patterns, becomes a completely meaningless endeavor.
② Semi-Strong Form Efficiency
- Definition: The hypothesis that not only historical information but also 'all publicly available information', such as news, earnings reports, and dividends, is reflected in the stock price the moment it is announced.
- Conclusion: Even 'Fundamental analysis' (value investing), which involves digging into financial statements and analyzing news to find cheap stocks, is completely useless for generating excess returns. This stage outright denies the methods of value investors like Warren Buffett.
③ Strong Form Efficiency
- Definition: The most extreme hypothesis that the market uncannily detects and reflects not only publicly available information but even 'undisclosed top-secret insider information' into the stock price.
- Conclusion: It declares that no matter what you do in this world, legally or illegally, you cannot beat the stock market.
3. Becoming the Faith of Passive Investing
This Efficient Market Hypothesis (EMH), combined with the previously discussed Modern Portfolio Theory (MPT) and Capital Asset Pricing Model (CAPM), became a massive religion that completely dominated Wall Street in the 1970s and 80s.
"Even if you pay expensive fees to an expert and join an actively managed fund, you can't beat the market anyway. So don't waste your effort; just buy the index fund with the lowest fees and bury it." Thanks to this powerful academic backing, John Bogle's Vanguard funds achieved massive success, and as seen in Evolution of Investment Chapter 2, the framework was completed so that we can comfortably invest in VOO today.
4. The Limitations of EMH and the Start of a New Evolution
However, the market, which seemed like a perfect 'rational computer', revealed a massive blind spot as it went through Black Monday in 1987 and the Dot-com bubble in 2000. People went crazy with greed and skyrocketed stock prices or panicked in fear and crashed the market, regardless of corporate value.
Eventually, the temple of EMH, which claimed "the market is always rational and perfect," began to crack, and a new academic discipline studying irrational human psychology stormed into the investment world. The rebellion of psychology that brought down the Efficient Market Hypothesis will continue in our serialized story, Evolution of Investment Chapter 3.