Key Points

  • Whether you agree with it or not, having a sound understanding of the Efficient Market Hypothesis (EMH) is critical.
  • Making active investment decisions requires factoring in all relevant and available information that may influence future performance and risk. This is a daunting task.
  • Nevertheless, according the EMH, the market is able to do this seamlessly and instantly.
  • According to theory, the markets have a way of equalizing prices such that all investment opportunities provide similar risk-adjusted returns on a go-forward basis.

Knowledge Is Power

In my last post we introduced the Efficient Market Hypothesis (EMH), which is arguably one of the most important theories in all of finance. And whether you agree with it or not, it is vital to have a sound understanding of this topic if you ever plan on investing in anything.

The Efficient Market Hypothesis (EMH) is an investment theory whereby share prices reflect all information and consistent alpha [market outperformance] generation is impossible. As such, it should be impossible to outperform the overall market through expert stock selection or market timing, and the only way an investor can possibly obtain higher returns is by purchasing riskier investments. — Investopedia

Recall from Part 1 of this post that our savvy investor was considering two investment options: Option A, investing in IBM over ten years, Option B, investing in Microsoft over the same period. Taking our two Options above into consideration, let’s say that our investor was strongly convinced that IBM was going provide a greater return than Microsoft over the next ten years.

How did this investor come to this conclusion? Well, this individual looked at every chart, every transcript, every statistic, ratio, and number related to both companies. The investor then read every news article, and thoroughly researched the background of both businesses, their managers, and their respective markets, and after extensive modelling, the investor came to this overwhelmingly confident conclusion that while both company’s stocks had about the same level of riskiness, IBM’s stock would provide a 10.0% annualized return over the next ten years, while Microsoft would only provide a 5.0% annualized return. Based upon this rigorous, complete, solid, and sound analysis, the investor then decides to invest in IBM.

But Some Knowledge Is Not So Helpful

Where could our all-star investor have gone wrong?

For starters, the investor used all publicly available information to draw this conclusion. The problem with this (according to the EMH) is so can everyone else; i.e., market participants have access to the same information that our investor does, and thus should come up with similar conclusions as our investor did.

As such, let’s say these market participants noticed what our investor happened to notice; namely that IBM was slated to considerably outperform Microsoft based upon currently available information. Here’s what would happen: first market participants would sell their shares of Microsoft, and then market participants would buy shares of IBM. This would result in the current share price of IBM increasing (given that higher demand leads to higher market prices), and the current share price of Microsoft decreasing (given that lower demand leads to lower market prices).

The net effect is that the average return that one would expect for IBM would quickly drop from 10.0% to something like 7.5%; and the average return that one would expect for Microsoft would increase from 5.0% to something like 7.5%. All of a sudden, there’s no real difference between investing in one company over the other. When I mention quickly above, what I really mean is more like instantly, given that with automated and computerized trading, markets can now adjust to new information before you can even load that web page that announces IBM’s latest earnings numbers.

When the Efficient Market Hypothesis states that markets are efficient, it implies that when any new piece of information becomes available, then share prices instantly adjust to their new price such that any investment with similar riskiness should provide investors with the same amount of return on a go-forward basis.

Of course, our investor thinks that markets are not efficient and further subject to irrational price movements; and granted, this is likely what most people think when they invest in stocks. So, rest assured, we’ll tackle this particular point in great detail before the end of this series.

About Risk

Also before we go further, let’s take a brief moment to talk about risk. In the above analysis we assumed that both stocks were just as risky as each other. So how did this assumption impact our analysis? Let’s see.

Risk is a big part of finance, and we’ll dig into this topic in its own series down the road, but for now, let’s define risk as the concerns relating to bad things that could potentially impact a company. Risk can be associated the chance of a company not being able to pay its bills, the chance that a company’s products will go obsolete, and even the chance that a company’s CEO might have a heart-attack. When we talk about estimating risk, we are essentially talking about estimating these types uncertain things, each of which could potentially impact the company’s future performance.

There are many heuristics that financial professionals use to estimate risk, but to keep it simple for now, let’s use a point system, where 10 means very risky (such as an investment in Bitcoin) and 1 means very safe (such as an investment in U.S. Treasuries). To put this into context, for our analysis above we assumed that both IBM and Microsoft both had about the same number of risk points, let’s say something like 5 risk points.

But what if one stock was more risky than the other? Does the Efficient Market Hypothesis fall apart? No, it does not. And here’s why. Let’s say that our investor’s rigorous analysis suggests that IBM has a riskiness of 3 risk points, while Microsoft has a riskiness of 5 risk points. If our investor now expected both stocks to have the same amount of annualized return over the next ten years, which stock would our investor pick? The investor would certainly pick the one that was less risky; so in this case, the investor would invest in IBM. So rather than just looking at return, we now understand that it can help to look at risk-adjusted return; i.e., return that takes risk into account.

The Markets Know All

Going back to our example, let’s say our investor’s analysis now suggests that both stocks have a target annualized return of 7.5% over the next ten years. Using the risk points above, our investor can obtain a risk-adjusted return by dividing the return by the number of risk-points. So the risk-adjusted return for IBM would be 7.5% divided by 3 risk points, which equals 2.5x (or a 2.5% return per risk point); while the risk-adjusted return for Microsoft would be 7.5% divided by 5, which equals 1.5x (or a 1.5% return per risk point). Thus, our investor should invest in IBM given that one can earn the same return with less risk; i.e. the risk-adjusted return of IBM is higher than that of Microsoft.

But not so fast. According to the EMH, here’s what would happen if there two stocks had differing risk-adjusted returns. The market would notice this divergence in risk-adjusted returns (having access to the same information and risk models as our investor), and market participants would place trades accordingly.

Thus, the share price of IBM would fall, leading to a lower expected annualized return for IBM from 7.5% to let’s say 6.0%; at the same time, the share price of Microsoft would rise, leading to a higher expected annualized return for Microsoft from 7.5% to let’s say 10.0%. As such, the risk-adjusted return for both stocks would now be 2.0x (math: IBM risk-adjusted return = 6.0% divided by 3 = 2.0x; Microsoft risk-adjusted return = 10.0% divided by 5 = 2.0x). Therefore, according to the EMH the market instantly adjusts such that the risk-adjusted return for these two stocks are equal.

Accordingly, if IBM were to now announce a new product, which market participants think will double the firm’s profit over time, in the past, our investor (and perhaps you) might have thought this would have been the perfect opportunity to invest in IBM. But you know better now. Here’s what’s already happened before you even get to the end of this sentence: other market participants (likely automated trading algorithms) have already determined that IBM is now undervalued, then these systems have already begun to increase their positions, and finally the share price of IBM has already been driven upward, all before you can even consider placing that buy order. And there goes all of your superlative profit potential out the window.

No Free Lunch Here

In fact, the grander insight is that the market will adjust such that all stocks (generally speaking) will provide investors with the same risk-adjusted return. Thus, the only reason you would invest in one stock over any other stock is if you wanted a higher return, but it would have to come with a higher risk such that your risk-adjusted return would be the same. Essentially, there’s no free lunch if you believe markets are efficient in this manner. The ramifications of this insight are huge.

And one might ask, if you believe this line of thinking, why would you ever devote your precious time to investing in stocks? Why indeed.

Given all of this, is this really a game you want to play? Let’s say our investor nevertheless still strongly believed that IBM will outperform Microsoft on a risk-adjusted basis over the next ten years. Just to prove out the investor’s hypothesis, here’s what our investor is also signing up for:

  1. Our investor must stay on top of very piece of information relating to each firm, the industry, the domestic and global economy (which doesn’t sleep by the way!), and the overall market.
  2. Our investor must be able to instantly incorporate this new information such that if the investor’s original target return or investment thesis were to change, the investor might need to either sell the investment or even buy more of it (while also getting ahead of the automated computerized traders that can already incorporate all of this information almost instantly).
  3. Our investor must also be aware of tax implications with the understanding that if the investor sells a profitable position too soon the investor may be subject to long-term and perhaps even short-term capital gains.
  4. Should the investor sell before the ten years are up, the investor would need to put that capital to work as fast as possible; after all, if you’re money isn’t working for you, it’s working against you.

To summarize, there’s really no reason why an investor or you should invest in one stock over another. Both IBM and Microsoft should provide investors with the same amount of return, given that they have the same amount risk associated with them; and even if both stocks have different levels of risk, both stocks should provide investors with the same amount of risk-adjusted return, assuming you think the EMH is a valid theory.

The Big Picture

Not only does the EMH hold for two stocks, it holds for any number of stocks, or for that matter, any number of investments. For example, if markets are efficient, that stamp collection should provide you with the same amount of risk-adjusted return as that investment in antique paintings, as that investment in real-estate. There are some caveats to this more general conclusion, but we’ll tackle these finer points in a future post.

According to the Efficient Market Hypothesis, the markets have a way of equalizing prices by factoring in future returns and future risk such that all investment opportunities provide similar risk-adjusted returns.

Wow. Let that sink in for a moment. I’m sure you telling yourself at this point, that sure, this is all good in theory, but in practice the investment universe can’t operate this simply. But rest assured, we’ll cover these concerns, and other criticisms to the EMH in depth by the end of this series.

At the end of the day, there must be an easier way to participate in the markets, and in fact, there is. Most of you probably know where I’m going with all of this, but before we dive into a potential solution to our investing dilemma, we’ll first need to review the basics of active” versus passive investing. But before we get to that, in my next post (Part 3), we’ll continue this series with a dive into the assumptions that underlie the Efficient Market Hypothesis, and in Part 4, we’ll discuss counter-evidence against the EMH.