- Three key assumptions underlie the Efficient Market Hypothesis.
- First, investors are rational and they invest rationally.
- Second, irrational investors exist, but they tend to cancel each other out.
- Third, rational investors eliminate any remaining mispricing caused by irrational investors.
Completing the Foundation
Now that we’ve discussed and reviewed the basics of Efficient Market Hypothesis (EMH) in Part 1 and Part 2 of this series, let’s discuss the its underlying assumptions in order to complete our foundation on this subject.
There are three assumptions that underlie the EMH. They are as follows (as detailed by Robert A. Strong, in his work on Practical Investment Management):
1. Investors are rational and value securities in a rational manner.
The chief notion here is that the price of securities are determined by market participants that collectively aim to maximize personal gain. As such, market participants will make thoughtful and sound decisions that incorporate all relevant information when trading securities. Thus, if a positive (negative) news release were to be released on Apple, rational investors will buy (sell) the stock only up until the point that this new information is fully reflected in the share price, at which point rational investors will stop trading. As previously discussed, one should expect this price adjustment to happen instantly, at least according to the theory.
2. To the extent investors are not rational, they trade randomly, so irrationalities tend to cancel each other out.
Of course, there will be market participants that haven’t done their “homework”. After all, it’s not so easy to be on top of every piece of information that may drive the price of a given stock. But also, we all have that friend that bought stock in Apple simply because he or she happened to like the company’s products. So the notion here is that these types of trades just add noise to the stock price but do not sway prices in either direction. This is because irrational stock traders includes both buyers and sellers, so these irrational market participants would tend to cancel each other out over time.
3. To the extent that investors are not randomly irrational, they are met in the marketplace by rational arbitrageurs, who eliminate any remaining irrational pricing elements.
Continuing with our example above, let’s say enough market participants like Apple’s products so much such that the price of Apple’s stock actually rallies far beyond what might be justified by the companies actual and expected performance. According to EMH, here’s what would happen: smart money (i.e. rational traders) would begin to sell off shares of Apple until the price of the stock falls back to what “it should be”, and again this should happen before you have a chance to place a similar trade on your end.
Thus, if these three assumptions hold, then EMH should hold, in which case, you’re better off not trying to pick stocks for a hobby or a career. But of course, there’s plenty of controversy behind EMH, as you must expect.
So, in Part 4 of this series, we’ll dive into the chief criticisms of the Efficient Market Hypothesis. And you may be surprised to learn, I agree with almost all of them.