market hypothesis (EMH)

The efficient market hypothesis (EMH) derived by Eugene Fama’s 1970 research is a theory which states that share prices reflect all information in the market and that they always trade at their fair market value on the stock exchange, therefore it is impossible to outperform the overall market through market timing or stock selection over the long term. It is also impossible to sell stocks for inflated prices or for investors to purchase undervalued stocks and the only way for an investor to achieve possible higher returns is to purchase riskier investments (Downey 2021).

The theory is highly controversial and often challenged, opponents to the EMH theory believe that stocks can deviate from their fair market value and that it is possible to outperform the market, where supporters say that investors benefit from investing in a low-cost, passive portfolio (Downey 2021).

Fama states that there are some deviations where company insiders or field specialist who have monopolistic access to information that are not accessed by the public could generate unexpected returns to some securities, however the model of the efficient markets is supportive and unique in economics and contradictory evidence against the EMH is minimal (Fama 1970).

In Burton G. Malkiel’s ’The Efficient Market Hypothesis and Its Critics’ piece he does review that fact that some investor do not necessarily make rational decisions and that this can cause pricing irregularities from time to time but these seem to be the exception and not the rule, and though the market is not ‘perfectly’ efficient it is itself still with these irregularities the value of the stock will level out and it would be hard for investors to have a method that would reliably obtain extraordinary returns to beat the market over time  (Malkel 2003).

Malkeil also delves into research about how the top 20 mutual funds have performed against the market over time since the 1970’s and although in some years they almost doubled the performance of the stock market the same funds also had years where they completely underperformed and hence they were unable to outperform the market over time, again there are exceptions where some managers have managed to out perform by a significant amount but these are few and far between, overall the majority could not produce greater returns in excess of the market (Malkel, 2003).

In Holton’s “Markowitz Wrong? Market Turmoil Fuels Non Traditional Approaches to Managing Investment Risks” she further looks into correlation risk and the impacts of diversified portfolios especially in situations like the 2008 market crash. Essentially even though the risk was spread out across may different asset classes everything lost out. While there  are risks in active asset management ie buying and selling at the right times and trying to time the market, there is more risk in buying and holding asset classes that are overvalued (Holton 2009).  Markets tend to behave similarly during times of high volatility. (Sandoval & Franca 2011).

Easton & Kerin, look at the distinction between micro-efficiency and macro-efficiency, and it shows that that the market tends to be micro-efficient however, at the macro level the information does not feed into the market quick enough. Governments are slow on picking up on macro-inefficiencies or intervene with regulation that does more harm than good, and therefore the market at times tends to be macro-inefficient (Easton & Kerin 2010).

In John Livanas 2006 article, “How can the market be efficient if investors are not rational?” he explores the alternative strategy of Prospect Theory where investors would use a framework in order to edit the information they deem to be of the most use then ‘edit’ this information, come out with probabilities which would assign a value, to assist the investor on choosing the best possible investments. This theory again still has some metrics to consider including the investors aversion to risk and loss and their rational and emotional behaviour. “Decision makers would need to make decisions that are more rational than a normal investor”. (Livanas 2006).

Furthermore Livanas explores Famas different forms of EMH being;

• Weak form
  consideration for historical information is reflected in the market price
• Semi-strong form
  consideration for historical and all publicly available information is reflected in the market price
• Strong form

consideration for historical, all publicly available information and monopolistic information is reflected in the market price

(Livanas 2006)

Taking this into consideration you would need to have at least a semi-strong form to allow the EMH theory to achieve the desired outcome (Livanas 2006).

(b) If the market is truly efficient according to Fama then investors who have no knowledge of the market, could simply purchase lower cost index funds and follow a passive investment strategy and come out better off than if they were to invest in an actively managed fund (Thune 2020). Ultimately though, the investor must ‘stay the course’ to get this benefit of the market over time, not make any irrational decisions and allow the market to correct itself, it is often the case with investors who do not have market knowledge or assistance from an adviser to guide them that they tend to move their money around at times that may not be in their best interest and have an adverse effect on their portfolio.

Strategic asset allocation may reduce correlation risk ensuring that overvalued stocks are not just held until their ‘bubbles burst’ therefore if done right may outperform the market overall, should active management be done right and the fees are not excessive then there is the possibility they can outperform the market (Holton 2009).  It is true that knowledge of market inefficiencies and using the irrationalities in pricing to quickly make excess returns in the market come up from time to time, these would have to be taken advantage of fast before market prices reflect these (Malkiel 2003).