Key Points

  • The Efficient Market Hypothesis has plenty of criticisms that are not only important to understand, but also have strong validity, and therefore should not be dismissed.
  • Boom and bust cycles provide strong evidence of pervasive market irrationality; nevertheless, this is not the same as knowing when irrationally exists and knowing when it will go away.
  • It is not enough to be able to spot irrationality because, “the markets can stay irrational longer than you can stay solvent”.
  • Rational and irrational investors may be unduly influenced by behavioral biases leading to the sustained, yet unpredictable mispricings of securities.

Nothing Is Perfect

The Efficient Market Hypothesis, the notion that trying to beat the markets is futile, as outlined in Part 1, Part 2, and Part 3 of this series, has many critics, including myself.

Of note, if everyone ascribed to this theory and its resulting implications, nobody would bother actively investing in stocks, or much of anything for that matter. But clearly, individuals can, do, and must make such investment decisions, so perhaps there’s more to this story. So let’s unpack the assumptions that underlie the theory, first mentioned in Part 3 of this series, and discuss where they may fall short.

The First EMH Assumption

1. Investors are rational and value securities in a rational manner.

The main criticism of this first assumption is that we all know and understand that humans can act irrationally, both individually and more importantly, collectively. And I’ll be the first to admit, so can the financial markets.

Clearly, financial markets experience boom and bust cycles as investors become overly optimistic and pessimistic. I’m sure we all recall the Dot Com bubble, and its subsequent bust. And of course, the Great Financial Crisis is a not-too-distant memory as well.

If markets were rational, many (perhaps correctly) argue, we would not experience such wild increases and then subsequent decreases in market prices. As an example, many of you may recall the crazy valuations of high-tech companies during the turn of the last century, some with absurdly high stock prices for companies with only a .com domain name and no revenue to speak of. Obviously, irrationally had taken hold on stock prices during this period, and few were surprised when it all came tumbling back down.

Given all of this turbulence one might want to consider alternatives to just buying and holding the market or to investing in the markets at all. Or perhaps there’s a “smarter” way to invest than these two alternatives? When faced with this type of uncertainty, Warren Buffett has some seemingly sage advice.

It is wise to be, “Fearful when others are greedy and greedy when others are fearful.” – Warren Buffett

This quote suggests that one should be pessimistic (and therefore sellers of stocks) when the markets are overly optimistic and optimistic (and therefore buyers of stocks) when markets are overly pessimistic.

According to this particular investment philosophy, by going against the crowd, one might then outperform the market over time by selling high and buying low. Seems simple, right?

My response to this sensible sounding advice is as follows:

Just because stocks behave irrationally from time-to-time does not necessarily mean that you can consistently beat the market over time.

In order to successfully beat the market in this fashion over a lifetime would require you to skillfully time your entry and exit points such that you don’t get out too early and don’t get back in too late when you invest in stocks. The successful timing of when to be invested is known in the finance industry as market timing, and as we’ll see in a future post, this type of investing is far easier said than done. In fact, many would say this is impossible to pull off.

This is a big point that I think most active investors miss.

Knowing that markets are irrational is not the same as knowing when this irrationally exists and knowing when this irrationally will go away.

For now, I’ll rest with the notion that of course some individuals will beat the market over their lifetimes, Warren Buffett being a good example. But it is also important to understand that just like at a casino, there will be winners, just by pure luck and randomness alone. Meaning, by just random chance, some few individuals have to beat the market. But as we’ll surely discuss in a future post, just as in a casino, the odds are not in your favor, especially if you’re Investing Forever. After all, as is true with any form of gambling, The House Always Wins.

The Second EMH Assumption

2. To the extent investors are not rational, they trade randomly, so irrationalities tend to cancel each other out.

The main criticism to this point is that there will be times when irrationally wins the day (or week, or month, or even year). However, you may have already heard the classical response to this particular criticism:

“the markets can stay irrational longer than you can stay solvent”

Here’s a hypothetical example of this situation. Let’s say you were firmly convinced that the market price of Apple was considerably higher than it should be. Your analysis may be sound; nevertheless, enough market participants may be happy holding Apple’s stock for irrational reasons.

In fact, these less savvy investors may even continue pushing up the price of Apple’s stock simply because other less savvy investors have recently pushed up the stock, even in the face of no new information on the company or its market, thus creating a vicious cycle of nonsensical escalating share prices.

The reason this can happen is nuanced, but important to understand. The notion is that there are two factors that drive the current price of a stock.

The first factor is the current performance of the company in relation to other companies. This information is largely known through financial statements, economic data, and other publicly available sources; and thus, this factor, although still challenging, is much easier to determine.

The second factor is the future performance of the company in relation to other companies. This information is largely unknown as it is based upon what will happen down the road, and thus open to interpretation and speculation.

Therefore, this second factor is largely driven by sentiment, meaning how favorable the company’s future performance appears to be in the eyes of market participants. Accordingly, if enough market participants have an overly favorable outlook on Apple’s prospects (irrational or not), the current share price of the company could stay overpriced for quite some time. And as mentioned, the stock price might even climb higher.

This means that if you were to short Apple’s stock (betting for it to fall in price) you might suffer considerably given the sizable influence of irrational market participants, even though your analysis for doing so is robust and sensible.

The Third EMH Assumption

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.

Here’s where the real fun starts. In our example above we claim that the price of Apple could stay elevated for extended periods for irrational reasons.

So why wouldn’t rational market participants and arbitrageurs just drive the price back down?

One reason is that if rational investors think that irrational investors will continue to drive up the price of Apple, these rational market participants may actually decide that they are better off not betting against the stock even if sound analysis suggests that this is a good idea.

After all, these rational investors also understand that the stock price can remain irrational longer than they would care to maintain a position. In fact, rational investors may also buy the stock in anticipation of other irrational investors driving Apple up even more. To make things more exciting, even more rational investors may purchase Apple in anticipation of other rational investors following other irrational investors. Yipe.

This type of (rational?) investing is an example of Behavioral Finance, where investors place trades based upon market psychology in addition to standard financial analysis. This particular behavioral effect aims to take advantage of the Trend Chasing Bias. The notion here is that stocks that have gone up in the past will continue to rise simply because market participants like buying stocks that have recently performed well, which then can be a self-fulfilling prophecy of sorts.

We’ve all heard the common disclaimer when it comes to investing, “past performance does not necessarily predict future results”. Nevertheless:

Investors often chase past performance in the mistaken belief that historical returns predict future investment performance.

For example, if you do not know much about efficient markets, but you keep seeing Apple in the news and you keep hearing that the stock continues to reach new highs, what are you more likely to do, buy or sell? That’s right you might buy without paying much notice to the company’s financials, the current state of its competition, or without even researching demand and supply forecasts for the firm’s products.

But also, let’s say you do know extensively about the markets, but you keep seeing Apple in the news, what are you more likely to do, buy or sell? You might buy just because you know other novice investors are more likely to buy.

That’s a Wrap

Ultimately, I think all these criticisms to the Efficient Market Hypothesis have strong merit. Nevertheless, I still think trying to beat the market is not the way-to-go in almost all situations. Essentially, even though financial markets can become wildly irrational, predicting when this irrationally exists and more importantly, when it will go away is next to impossible.

To better understand why I think so, we’ll first need to lay some more groundwork. As such, in my next series we’ll discuss the two main categories of investing, which are known as, active investing and passive investing, and I’ll also discuss why the latter approach can provide even the novice investor with substantial benefit.

But for now, we’ll conclude this series with the understanding that if you believe the EMH, then you should likely conclude that investing in one thing over another is not likely to provide you with superlative risk-adjusted returns. And even if you don’t fully believe in the EMH, consistently beating the market over your lifetime can still be an almost impossible challenge, as we’ll begin to see in my next series.