Why is the efficient market hypothesis unreasonable?

Table of Contents

Efficient Market Hypothesis background

Where did it come from?

The Efficient Market Hypothesis (EMH) is an investment theory proposed by Eugene Fama of the University of Chicago in the 1970s (so the University of Chicago Business School was later called the base of the Efficient Market Hypothesis by outsiders). The general idea is that a market in which stock prices reflect all available public information at any point in time is called an efficient market.

Unreasonable assumptions

At first glance, this hypothesis seems plausible. But this theory is actually based on many beautiful assumptions:

Investors are rational and will not be influenced by others.
All investors will be instantly informed of all the market news, and will immediately react in their favor.
The stock price has already reflected the intrinsic value, and there is no arbitrage; the average return of investors will be close to the performance of the stock market, and no one can beat the market for a long time.

Unreal

After reading these perfect assumptions, most investors with investment experience must have a hard time agreeing with this view. However, since the Efficient Market Hypothesis was put forward, it has been regarded as the standard by many world-renowned business schools, and it still has many followers. It can be seen that there is a big gap between theory and practice.

What about the real world?

This is what we have in the real market:

It simply a recognition that in investing we deal always with probabilities and possibilities, never with certainties. It follows as night the day that in investing that odds are all important.
Buyers and sellers all based on informatin they are confident, but what make them have oposite opinions?
- Sellers have better investing alternatives
- No one can be informed about the future, people’s decision are base on assumption they made, lead to different conclusion.
- No one ever is or or can be fully informed
Fresh or true information, ther is no way to verify
Even if ten thousands investors have heard the news ahead of you, it may still prove profitable to you if 10M investors are going to hear it and act on it after you.

Buffett’s comments on EMT

In his 1988 Letter to Shareholders, Buffett wrote:

The preceding discussion about arbitrage makes a small discussion of “efficient market theory” (EMT) also seem relevant. This doctrine became highly fashionable ‐ indeed, almost holy scripture in academic circles during the 1970s. Essentially, it said that analyzing stocks was useless because all public information about them was appropriately reflected in their prices. In other words, the market always knew everything.

As a corollary, the professors who taught EMT said that someone throwing darts at the stock tables could select a stock portfolio having prospects just as good as one selected by the brightest, most hard‐working security analyst. Amazingly, EMT was embraced not only by academics, but by many investment professionals and corporate managers as well. Observing correctly that the market was frequently efficient, they went on to conclude incorrectly that it was always efficient. The difference between these propositions is night and day.

In my opinion, the continuous 63‐year arbitrage experience of Graham‐Newman Corp. Buffett Partnership, and Berkshire illustrates just how foolish EMT is. (There’s plenty of other evidence, also.) While at Graham‐Newman, I made a study of its earnings from arbitrage during the entire 1926‐1956 lifespan of the company. Unleveraged returns averaged 20% per year.

Starting in 1956, I applied Ben Graham’s arbitrage principles, first at Buffett Partnership and then Berkshire. Though I’ve not made an exact calculation, I have done enough work to know that the 1956‐1988 returns averaged well over 20%. (Of course, I operated in an environment far more favorable than Ben’s; he had 1929‐1932 to contend with.)

All of the conditions are present that are required for a fair test of portfolio performance: (1) the three organizations traded hundreds of different securities while building this 63‐year record; (2) the results are not skewed by a few fortunate experiences; (3) we did not have to dig for obscure facts or develop keen insights about products or managements ‐ we simply acted on highly‐publicized events; and (4) our arbitrage positions were a clearly identified universe ‐ they have not been selected by hindsight.

Over the 63 years, the general market delivered just under a 10% annual return, including dividends. That means $1,000 would have grown to $405,000 if all income had been reinvested. A 20% rate of return, however, would have produced $97 million. That strikes us as a statistically‐significant differential that might, conceivably, arouse one’s curiosity.

Yet proponents of the theory have never seemed interested in discordant evidence of this type. True, they don’t talk quite as much about their theory today as they used to. But no one, to my knowledge, has ever said he was wrong, no matter how many thousands of students he has sent forth misinstructed. EMT, moreover, continues to be an integral part of the investment curriculum at major business schools. Apparently, a reluctance to recant, and thereby to demystify the priesthood, is not limited to theologians.

Naturally the disservice done students and gullible investment professionals who have swallowed EMT has been an extraordinary service to us and other followers of Graham. In any sort of a contest ‐ financial, mental, or physical ‐ it’s an enormous advantage to have opponents who have been taught that it’s useless to even try. From a selfish point of view, Grahamites should probably endow chairs to ensure the perpetual teaching of EMT.

All this said, a warning is appropriate. Arbitrage has looked easy recently. But this is not a form of investing that guarantees profits of 20% a year or, for that matter, profits of any kind. As noted, the market is reasonably efficient much of the time: For every arbitrage opportunity we seized in that 63‐year period, many more were foregone because they seemed properly‐priced.

An investor cannot obtain superior profits from stocks by simply committing to a specific investment category or style. He can earn them only by carefully evaluating facts and continuously exercising discipline. Investing in arbitrage situations, per se, is no better a strategy than selecting a portfolio by
throwing darts.

Buffett’s fundamental thought

Most academic classes are not helpful

In his 1996 Letter to Shareholders, Buffett wrote:

“To invest successfully, you need not understand beta, efficient markets, modern portfolio theory, option pricing or emerging markets. You may, in fact, be better off knowing nothing of these. That, of course, is not the prevailing view at most business schools, whose finance curriculum tends to be dominated by such subjects. In our view, though, investment students need only two well-taught courses – How to Value a Business, and How to Think About Market Prices.”

Difficult does not mean useful

In his 1987 shareholders letter, he said:

As he put it in his “1987 Berkshire Letter to Shareholders”:

Ben’s Mr. Market allegory may seem out-of-date in today’s
investment world, in which most professionals and academicians
talk of efficient markets, dynamic hedging and betas. Their
interest in such matters is understandable, since techniques
shrouded in mystery clearly have value to the purveyor of
investment advice. After all, what witch doctor has ever
achieved fame and fortune by simply advising “Take two aspirins”?

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